Stocks Splits Shouldn’t Matter…But they do

A stock split shouldn’t actually matter in terms of valuing a company, but for some reason they do.  A stock split is when a company divides its stock (often you’ll see 2 for 1 or 10 for 1 stock splits) to shareholders on a date certain.  For example, MasterCard announced a 10 for 1 stock split recently which provides that shareholders as of January 9 will get 10 shares for every 1 share they own on that day on January 21.

Why Shouldn’t a Stock Split Matter?

Imagine you have a pie (mmmm pie) that was split into 4 pieces and you own 25% of it.  Now the pie gods say I am taking that same exact pie and splitting it into 8 pieces but you are getting 2 pieces (i.e. still that same 25%).  Did anything really change? No you have the same amount of pie goodness in your life.

To continue the implied metaphor…the pie is the company (mind blown like the first time you saw Fight Club?).  So on January 20, 2014 if your 1 share of MasterCard was worth .000000000000001% of the company on January 21, 2013 your 10 shares will still be worth .000000000000001% of the company.  So for the retail investor nothing is supposed to change.

Why Does a Stock Split Matter?

Investopedia provides some very good reasons why a stock split does change things:

  • The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more “attractive” level. The effect here is purely psychological. (Editor’s note: As discussed above)
  • Another reason, and arguably a more logical one, for splitting a stock is to increase a stock’s liquidity, which increases with the stock’s number of outstanding shares. When stocks get into the hundreds of dollars per share, very large bid/ask spreads can result.

Lastly, there is a discussion of whether it affects those that might be charged on a per share basis for trades.  This doesn’t affect most retail investors, but depending if you are for or against high frequency trading there is a pro/con.  It would take HFT more shares to move the same amount of capital, and as such, it could increase their trading costs a bit. Again, this has little to do with 92% of retail investors.

While I believe it to be a purely psychological…it doesn’t matter if there is empirical proof that the shares continue to rise thereafter making those that make those decisions wealthier.

6 Responses to Stocks Splits Shouldn’t Matter…But they do

  1. Agreed that stock splits shouldn’t matter, but oftentimes the market moves on emotion. Companies that split their stocks are seen as confident growers, so the price often goes up. Like you said, it’s purely psychological.

      • It goes to show that there is typically no added value in active management, and all individual investors are better served with low-cost passive index funds.

        • My dividend portfolio is pure active management – by me! Seriously though I go back and forth on the topic and since I can’t decide I have a little in both passive and active

  2. I had always wondered why this was. I knew the psychological factor in it was one thing. For example Berkshire Hathaway class B stocks were over $3,000 each a few years ago before the last split. Most average investors probably found that to be a high bar to get into. And the cost of their class A stocks….. Well, let’s just say I’d rather have a house than 1 share of a stock.

    But I had never thought about the liquidity factor before. It makes perfect sense though.

    Do you think that lowering the price per share hurts or helps a company? It lowers the entry point to getting in, and in mastercards case it went from around $800 to somewhere about $80.

    There’s the idea that if you can’t afford to invest $800 then why are you investing in individual stocks to begin with. So lowering the bar to $80 per share does what? brings in the people that probably shouldn’t be investing in the first place? Does that actually help a company or does it just inflate it’s price for no apparent reason?

    • I am in the middle of reading each one of Buffett’s shareholder letters and I forget the year but he mentioned why BRK created the Class B Shares. His rationale was that there were investment advisors creating investment trusts that would only own BRK and then sell the units of the trust (with a fee of course). So his thought process was to create a new class of shares whose value would stay one-thirtieth of Class A Shares.

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