With Stock Splits, Perception Hopes to Create a New Reality
Over the span of two months, three of the world’s most prominent companies – Google-parent Alphabet, Amazon and Tesla – announced they would split their stock. Each of these companies have two things in common: stocks above $1,000 and market caps north of $1 trillion. But the recent share-splitting trend is not limited to the ultra-mega caps, as evidenced by GameStop’s recent filing announcing plans to increase its share count by more than 3x for the purposes of a stock split, which sent its shares up.
Their decision to split fits the conventional wisdom: splitting turns a $1,000 stock into a $500 stock (or $200, or $100, depending on the chosen split ratio) which theoretically becomes more appealing and approachable to retail investors. For companies that have share prices a little more down to earth, a stock split is not a clear-cut decision, and in some cases may actually be unwise.
The following are some guidelines to consider when contemplating a stock split.
Reasons To Execute a Stock Split
- Shows confidence in long-term strategy: Splitting your company’s stock is viewed as a sign of management’s confidence that the company – and its share price – will grow. It is accepted by Wall Street that a company would only cut its stock price in half, or in thirds, or even twentieths (Amazon & Alphabet) if it was optimistic about its growth prospects. Similarly, a company would not cut its stock if management thought the price would subsequently drop in the near future. Management and Board optimism about future growth is taken as a positive signal by Wall Street, which is why shares of Alphabet, Amazon and Tesla all surged after their splits were announced.
- More attractive for retail investors: A share price in the high hundreds or north of $1,000 is often seen as expensive, even if it is in fact a good value. When that $1,000 stock becomes $500 or even $50, then suddenly it can seem more appealing to the average investor, even if it is still the same slice of the company they are buying. A lower dollar price is simply more attractive. And even with the proliferation of fractional share investing, owning whole shares also seems more appealing to individual investors.
- Helps attract, retain and incentivize employees: When a share price is halved in a 2-for-1 stock split, the number of shares is doubled. When an employee sees their 1,000 shares balloon to 2,000, that bigger number can have a positive effect as the number of shares or options they receive as part of compensation packages are upsized. That was part of the rationale for a recently announced 3-for-1 split by furniture retailer Restoration Hardware (RH).
- Influence of the Retail Options Market?: In a recent Bloomberg Opinion piece, Matt Levine explores the potential that stock splits can actually increase value. He points out the recent meme stock phenomena suggests that there may be more substance to the influence of retail investors in the options market than previously considered. And because call options must be traded on an exchange – which only trade in 100-share contract blocks – having a lower price-per-share makes purchasing call options more accessible to smaller investors.
- Easier to project EPS: Time for some math. A stock split increases the total number of outstanding shares, which is the denominator in earnings per share. The larger that number, the more accurately a CFO can predict the numerator, or the earnings. It takes more variability of the earnings to move the needle by one cent in either direction.
Reasons To Think Twice About a Stock Split
- Harder to exceed EPS: The flip side to an easier-to-predict EPS is that guidance is harder to beat. For the same reason as above, a company needs much more net income (the numerator) to move the needle by one cent in either direction, given the larger share base. If a company had 1 share, it would take only 1 dollar of net income to change EPS. If a company had 100 shares, it would take 100 dollars of net income to change EPS.
- Lower stock price: A split that takes a company share price too low – say $20 – leaves the stock more vulnerable to fluctuations. A market correction or an earnings miss could push a stock down even further, potentially into a range that would trigger guidelines at mutual funds or other institutions on minimum share price for its holdings.
- Fractional Shares: As we said at the top, the conventional wisdom is that a lower stock price is more appealing to retail investors. Nowadays, investors can buy fractions of a share, which makes a $1,000+ stock more accessible anyway. Do individual investors really care if they own one share or one-eight of a share, if it has the same value? Hard to know for sure.
- Institutional investors see through it: Professional investors realize a stock split is just optics and that it doesn’t create any actual value. There could be a risk that such a move could be perceived by Wall Street as a gimmick, and negatively impact management credibility.
Reverse Stock Splits
Just as a company might want to lower its stock price in a split, a reverse stock split allows a company to divide its outstanding shares and boost a depressed stock price. Oftentimes, companies executing reverse splits are in danger of otherwise being de-listed from an exchange due to a low stock price. It can also be a viable tactic for smaller companies with strong potential to boost their profile and garner more attention from institutional investors. These too come with cautionary tales.
- Short sellers lick their chops: For low-priced stocks, reverse splits are viewed attractively by short sellers because there is more room between the raised price and zero. That is, more room for the stock to fall.
- Less is not always perceived as more: Employees may not like hearing that their 100 shares or options became 25, even if those 25 shares hold four times the value. All they see is fewer shares.
Understand the pros and cons of a stock split before making the move. Learn how ICR can help.