How Stock Splits Work and Why They Matter

Photo (cc) by raneko

I’ve been investing in stocks for 35 years, 10 of which I spent as a stockbroker. Over the decades I’ve made some smart moves, some dumb ones and some lucky ones. But there’s one lucky investment that outshines all others — the investing equivalent of winning the lottery.

I bought Apple stock in 2001. If memory serves, I invested about $1,700. I sold half in 2008 for about $35,000, and my remaining 200 shares are now worth about $120,000.

Like I said, the investing equivalent of winning the lottery.

On June 2, Apple will be splitting seven for one. That means that after the split, for every share I have now, I’ll have seven. So instead of 200 shares, I’ll have 1,400. But will that make me richer? For answers, check out this video we recently shot using an apple and cutting board to explain stock splits.

Now let’s delve a little deeper, starting at the beginning.

What’s a stock?

Suppose you were my partner in MoneyTalksNews.com. We’re making money, but we’d like to make a lot more. To accomplish that, we need more readers.

We kick around a few ideas and finally decide to attract new readers by buying a few ads during the Super Bowl. The problem: Thirty-second Super Bowl spots cost $4 million. Since we’d like to buy several spots, as well as pay for producing clever commercials, we figure we’ll need about $20 million to make it happen.

Since we don’t have $20 million lying around, we’re faced with two choices: Either we borrow it, or raise money from investors by selling off part of the company.

We quickly learn that no bank is going to lend us $20 million, so we decide to sell part of the company by issuing stock.

We hire an investment bank, say Goldman Sachs, and after they examine the company they tell us MoneyTalksNews.com is worth about $40 million. With their help, we issue 40 million shares of stock, pricing each at $1. We keep half — 20 million shares — and sell the other 20 million to the public by listing our stock on the New York Stock Exchange under the symbol MTN. Goldman generates interest in the stock by issuing and publicizing a report singing our company’s praises.

We’ve now sold half our company, raised $20 million, and anyone can buy and sell our stock on the NYSE. Super Bowl, here we come.

Why split it?

Turns out, our Super Bowl ad idea was a great one. The exposure causes our readership, and profits, to explode. Even though we now own only half the company and have to share profits with our stockholders, it was well worth it.

As our company becomes more profitable, our bank account swells. Our business is worth more, which means each share of MTN stock is worth more.

Ten years after our initial public offering (IPO), MoneyTalksNews.com is the dominent force in consumer news, eclipsing competitors like The New York Times, CNN and The Wall Street Journal. Our stock price has risen with our stature, increasing from $1 to $700 per share.

But with our success comes a problem. Our customer base is the general public, and we want to increase loyalty to our brand by encouraging the general public to own our stock. But now our stock has gotten so expensive, few of our readers can afford even one share.

Time for a stock split.

We decide to split our stock seven for one, meaning everyone who owns one share of MTN will get six more, free. But those shares will be worth only one-seventh of what they are now. Before the split, they were worth $700. After, they’ll be going for $100, making them easier to afford.

Nobody’s getting richer

You’ll recall that when we first went public, we issued 40 million shares, selling half to the public and keeping half for ourselves. If we now decide to split the stock seven for one, there will be seven times that number — a total of 280 million shares. Our half of the company used to be 20 million shares; now it will be 140 million. Shares available to be bought and sold by the public will now total 140 million as well.

Although we’ve increased the number of shares sevenfold, note that we haven’t gotten any richer. We owned half the company before the split, and we still do. Changing the number of the shares didn’t increase our 50 percent stake, nor did it make the company more valuable. It’s really just an accounting entry, done simply to make shares more affordable to the public.

Sometimes split stocks go up

Although stock splits alone don’t make anyone richer, ironically they sometimes can make shareholders richer.

Stocks that split often outperform those that don’t. There are several possible reasons:

  • More demand. More people can buy a $100 stock than a $700 stock. Additional buyers means more demand, which can lead to higher prices.
  • Confidence. When management splits a stock, they’re giving an indication they expect their stock to go higher. After all, if they expected it to go lower, they wouldn’t be splitting it.
  • Publicity. When a company splits a stock, especially when the company is a household name (like Apple), it draws media attention. That publicity could result in more buyers.
  • History. There is empirical evidence that split stocks outperform. One oft-quoted study called “What Do Stock Splits Really Signal” claims the stocks of companies that split outperform the overall market by nearly 8 percent in the year following the split and by nearly 12 percent annually in the three years following the split.
  • Self-fulfilling prophecy. Why split stocks outperform isn’t as important as the fact that they do. Since that’s been accepted by many investors, splits attract buyers.

In short, stocks that split have historically proven to be good bets, despite the split itself not creating value. The reason is more likely related to the fact that companies splitting stocks often happen to be companies making lots of money. Companies, for example, like Apple.

Should you buy Apple?

After the reasons I’ve highlighted, should you run out and buy Apple before it splits?

Absolutely not, at least not solely due to the split.

You put money in a company because you believe it has good products, good prospects and good management.

When I bought Apple in 2001, I was attracted to it for a simple reason: I kept seeing iPods everywhere. While I didn’t immediately pony up for an iPod for myself — too rich for my blood — a lot of my friends did. It was easy to see that iPods were becoming a status symbol, a must-have. Apple’s earnings were mushrooming, and I’d read lots of good things about the company’s leader, Steve Jobs.

A stock I owned at the time, Dell, lacked these qualities. Since Dell was priced similarly to Apple, I sold Dell and used the proceeds to buy Apple.

Rising earnings, great prospects, solid management — that’s the “cake” when it comes to investing. Things like stock splits from companies you already like are the icing.

Want to see if Apple is a good buy? Forget the split and focus instead on the tons of information currently available online. You can see everything from earnings growth to what analysts are saying, at sites like MSN Money, Yahoo and The Street.

Will it seem like gibberish at first? You bet. But it’s not rocket science; it just takes a little time. And it could be time well spent, especially if your dreams include turning $2,000 into $150,000.

Disclosure: The information you read here is always objective. However, we sometimes receive compensation when you click links within our stories.

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