Dylan Lewis: Hey, I’m fool.com editor, Dylan
Lewis, and on this episode of FAQ, we’re going to talk pizza and stock splits.
OK, I’m going to offer you two different options. You can have one slice of a 12 inch pizza
that’s been cut into quarters, or you can have two slices of a 12 inch pizza that’s
been cut into eighths. Which one do you choose? Think about your answer. While you do,
let’s walk through what a stock split is. All companies that are publicly traded have
a certain number of shares outstanding. Let’s say I have a publicly traded company that’s
worth $1 million, and ownership of that company is divided into 10,000 shares outstanding,
so each share is worth $100. Now, say my company puts up some awesome business results.
We released a bunch of new products, those products sell really well, and customers are happy.
Thanks to the massive boost in sales over a few years, the business grows to $10 million
in value. Now each share is worth $1,000 at this point. As management, I might look at
that and say, “You know, that’s a lot of money that people need to have in order to become
a shareholder of my company. I want to make sure that the average person can buy one share
and become an investor.” If that’s the case, I might decide to do a stock split.
Say I do a five-for-one split. One share now becomes five, so the total shares outstanding
will become 50,000 for the company, and the price of each share will go from $1,000 to $200.
The total value of the business stays the same. The total value each shareholder
holds stays the same. The only thing that changes is the number of shares and how much
they’re worth. That five-for-one example was for the sake of round numbers and math
skills. Most stock splits are either two-for-one or three-for-two.
Now, you might be thinking, why? If stock splits do nothing for the value, why
do companies do them? Well, companies might decide to do it to make it easier for the average investor
to buy shares. If someone is trying to save $100 a month to invest, they have to wait
a lot longer to buy shares if they want to buy shares that are priced at $1,000 instead
of $50. This was the main reason Apple cited for going through a seven-for-one stock split
a few years ago. Apple CEO Tim Cook said in 2014, “We’re taking this action to make Apple
stock more accessible to a larger number of investors.” Companies will also do this because there are some special securities, like options,
that are sold in lots of 100. We’ll talk about options on a future episode, but for the
purposes here, just know that they generally need to be sold in blocks of 100 shares. So if a
company’s stock price is very high, it requires a lot of money upfront to transact these options.
Like the previous reason, companies might split their stock to make it
easier for people to do that. One third reason that you’ll see companies
go through a stock split is that it increases the number of shares outstanding,
meaning there are more available shares to trade, which can help with liquidity.
Now, there are actually some companies that intentionally avoid splitting their stock.
The main reason: stock splits are cosmetic changes to a company’s ownership. They don’t
change the fundamentals of the business at all. And a high share price tends to attract
long-term, buy-and-hold investors, and actually makes it harder for people to short-term trade
in and out of a company. This quote from Warren Buffett’s 1983
annual letter to Berkshire Hathaway shareholders pretty much sums it up. “Were we to split the stock or take other
actions focusing on stock price rather than business value, we would attract an entering
class of buyers inferior to the exiting class of sellers. Could we really improve our shareholder
group by trading some of our present, clear-thinking members for impressionable new ones, who preferring
paper to value, feel wealthier with nine $10 bills than one $100 bill?” Buffett ultimately
caved and created a separate class of Berkshire shares in a split, but he’s never split the
voting Berkshire A shares, which currently trade at over $300,000 each.
More management teams are starting to think like Buffett. In 1997, over 100 companies
in the S&P 500 split their stocks. In 2016, that figure was down to seven. Executives
are wising up to the fact that stock splits aren’t worth their time, and the rise of brokerages
offering fractional shares have made it easier for investors with less money to still get
into the market. You’ll hear people say, “Oh, stock splits are a bullish sign, it means
the company thinks they’re going to keep growing and the share price is going to keep going up.”
No. It’s just shuffling around how ownership is held. Going back to our
pizza example, some people might prefer to get two smaller slices instead
of one monster piece of pizza. The reality is, you’re getting the same amount of pizza
either way. The same goes for a stock split. There may be some short-term movements related
to the news, but long-term, shares move because of the business results that companies put up,
not the number of ways ownership is sliced up. Thanks for watching, guys! If you enjoyed this video, we’ve got plenty more like it
coming up. Hit subscribe down in the bottom right and give us a thumbs up. If you have
any questions on things I hit in the video, drop them in the comments section below.
We love getting ideas for future videos!