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
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