What is a Stock Split and Why do Companies Do It?

Joel Anderson |

On April 23, Apple (AAPL) crushed earnings expectations, but that was old news before it even hit the markets. The real news in the company’s quarterly report was the announcement of a 7 for 1 stock split. That is, for every one share of Apple stock a person owns as of June 5th, as of June 6th they will have seven.

For market outsiders, this is a positively mystifying move. Why would a company do this? CAN a company do this?

The answer to the latter question is "yes, definitely." The Board of Directors, who are elected by a company’s shareholders, can decide to slice and dice the company into as many pieces as they want.

The question of "why," though, is a bit more complex. In the end, there are some solid, very logical reasons for performing stock splits. However, some of the biggest reasons actually have more to do with public perception and crowd psychology than with sound, reasonable market dynamics.

Building a Bigger Tent for More Investors

Given that companies can create or destroy shares at will, the price of an individual share of stock would seem to be largely arbitrary. The total value of the company is settled by the open market, and then that value is broken into a bunch of different pieces (shares). A $100 million company with 1 million outstanding shares will have a share price of $100 a share. A $100 million company with 100 million outstanding shares will have a share price of $1. The companies are worth the same despite the big difference in share price.

While arbitrary in some ways, share price can have a very real effect on how a stock trades. Higher share prices mean lower liquidity, and a share price that’s too high can drive away retail investors looking to make smaller investments. If someone’s going to invest $500 in stock, and your shares are $750 apiece, you’ve effectively priced yourself out of that market.

This is, however, a relatively minor consideration. Apple’s stock was trading at $524.75 the day they announced the split, meaning the new shares would hypothetically be priced at $74.96 a share. However, the number of people planning on investing in increments small enough that a shift from just under $525 a share to just under $75 would be decisive is pretty small. What’s more, they’re clearly not bringing a ton of money to the party, meaning they’re unlikely to move the needle on the stock very far.

Obviously, any additional buying pressure is appreciated for people already holding the stock, but you’re not going to make a move this big just to bring a handful of people trading less than $500 in stock to the party.

Share Price Creates a Perception

So, as is often the case in the stock markets, getting to the real answer involves accepting that investors aren’t completely rational.

Sure, a person investing $5,000 in a company shouldn’t really care about whether they’re getting one $5,000 share or 1,000 $5 shares, but the reality is that many do. Holding 1,000 shares feels different than holding one share for a lot of people, even if the returns are exactly the same. There’s an element of "sticker shock" to a single share that costs hundreds or thousands of dollars.

As such, a high share price can scare off a lot of investors and decrease the amount of stock trading hands. And, in the end, that can mean your company’s market value is lower than it can be. Again, whatever motivates it, buying pressure will increase share price, and a lower share price ultimately attracts more people and boosts said buying pressure.

Lower Share Price Not Always a Good Thing

So, more people trading your stock seems like it would always be a good thing, right? More investors, more shares trading hands, higher total market value for your company. Seems like everyone would be shooting for a share price around a dollar, right?

But Warren Buffett, the Oracle of Omaha and one of the most respected investors out there, is adamantly opposed to stock splits. In fact, Buffett’s company, Berkshire Hathaway ($BRK.A), has A-shares that trade for over $190,000. Apiece.

That staggeringly high share price all but ensures that about 99 percent of the investing public and 99.9999 percent of the general public can’t seriously consider investing; Buffett’s priced himself out of most of the market. So, given that we can probably agree that Buffett’s no fool when it comes to the stock market, why such a ridiculously high share price?

In short, because Buffett doesn’t want people who can’t pony up at least 200 grand as his shareholders.

While opening up your stock to investment by a wider swath of the investing community means higher volume and, probably, improving total market value, it can also mean a lot more volatility. The same investors who can be attracted by something like a stock split aren’t likely to stick with a company through tough times.

After all, they could be wooed by something as simple as reducing the price of individual shares. Are these investors Buffett can expect to be patient with the markets? Will they stick through touch times? Or will they get spooked by one bad quarter and turn into knee-jerk sellers, potentially turning that bad quarter into a bad year? Some surely will, but enough won’t, making Buffett’s job that much harder.

That’s why Buffett wants the sort of stodgy, institutional buyers who will hold onto shares for years or even decades as long as they see value in the company (investors who are just like he is in that regard). Sure, a spike in the stock might be great in the short term, but Buffett will happily sacrifice those short term gains for a base of rock-solid investors he can count on through thick and thin.

Reverse Stock Splits

Of course, some companies will perform reverse stock splits, cutting the size of their float (the total number of outstanding shares) by a half, two thirds, or more to increase their share price.

In part, this can be to reduce volatility. If a company’s stock is trading for a few dollars a share and whipsawing investors with big price swings from day to day, those investors a large stake aren’t going to be happy. If you perform a 2-to-1 reverse split (whereby every two shares are turned into one), your share price doubles and maybe the sort skittish buyers creating that volatility will stop showing interest.

But, once again, it’s also a matter of perception. A share price that’s low enough is often perceived as having a lack of legitimacy. The phrase “penny stock,” for example, is widely accepted as one that implies a lack of respectability. And the major exchanges actually require companies to maintain a certain share price to continue trading on the exchange. If your company’s share price plunges too far, you could be risking a market perception that you’re small potatoes or, worse, an embarrassing delisting that will likely spark a big decline.

Pricing Strategies Can Vary

In the end, Warren Buffett’s approach has some benefits…and some drawbacks. As does Apple’s. And the idea that either strategy is inherently better or worse would not be a good one. Each individual company is likely to have different factors motivating decisions about how much stock it has on the market.

In Apple’s case, the decision to split their stock would seem to indicate that the company’s shifting gears to focus on returning value to its shareholders rather than innovating new products. In Berkshire Hathaway’s, maintaining a sky-high share price helps them remain a stable investment for very wealthy investors to feel confident in.

However, understanding stock splits remains important before you dip your toe into the stock market.

 

1 It’s worth noting that the decision to split a stock while also engaging a massive share buyback would appear pretty odd to an outsider. The purpose of the split is to put a lot more shares out on the market, but the purpose of the buyback is to take them off the market. In the end, you’ll have to trust that it works. Apple’s going to get the lower share price they want, but they’re also going to bolster the total value of investor equity by taking $30 billion worth of shares out of circulation. Doing them at the same time, while confusing, is still pretty good for anyone who owns Apple.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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Symbol Name Price Change % Volume
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