Your Share of the Pie

Answer: Although the leftovers from Thanksgiving are long gone, let’s use a pie analogy to illustrate how stock splits work. Think of Netflix as a giant pie worth around $500 billion dollars. To keep the math simple, we’ll use round numbers. Before the stock split there were approximately 500 million shares (slices) each priced at roughly $1,100 per share. That’s a pretty high price for most investors.

Why Companies Would Announce Stock Splits

To make shares more accessible, Netflix announced a 10-for-1 stock split. The value of the company, or size of the pie, stays the same, but it’s cut into 10 times as many slices or shares. After the split, each share is worth approximately 1/10th as much as the old one, meaning the price per share of Netflix becomes $110 instead of $1,100.

The value of the total pie, or company, remains exactly the same at $500 billion, but there are now more slices, or shares outstanding at a lower price per share. The value of the company, and the value of investors’ holdings remains the same at that point in time. Psychologically, a lower price per share may make it more attractive for investors to purchase shares.

Splits typically signal confidence by a company and are announced and implemented when the outlook for growth and profitability is strong. Occasionally, stock splits are followed by a bump in stock performance, but not always. Stock splits have no concrete impact on a company’s total value; they simply create more shares at lower prices.

Stock splits are an expensive proposition for companies and require a great deal of legal oversight to ensure companies adhere to regulatory rules. It’s worth noting that stock splits aren’t a taxable event for shareholders, but the cost basis per share is adjusted.

Owning more shares at a lower price after a stock split may sound like a good thing, especially if the lower price per share might mean there’s room for potential upside price growth. However, investors shouldn’t buy a stock just because they think the price will rise in price after a split. A company’s value is determined by earnings, not the stock price.

Reverse Splits: When the Pie Shrinks

Stock splits can go in the other direction, too. Reverse stock splits reduce the number of shares and raise the price per share. This often carries a stigma of financial distress for a company. Psychologically, an increased price per share may improve investors’ perceptions of stability for a company, although nothing fundamentally changes and the total dollar value owned by the investor remains the same.

Citigroup’s stock price fell below $5/share after the 2008 financial crisis. For a company to be listed on the NYSE it must have a minimum price of $1/share. For this reason and more, on May 6, 2011, Citigroup declared a 10:1 reverse stock split. For every 10 shares of Citigroup, shareholders received 1 post-split share and the price per share increased.

Since its initial public offering, Netflix has had four splits with the most recent being announced on November 10th with shares distributed November 14th. Using our math examples, if the pre-split price were $1,100, the post-split price would be around $110 per share.

To summarize, traditional stock splits provide more shares and lead to a lower price per share. Reverse stock splits are designed to create higher prices with fewer shares to boost sinking share prices. In both cases the total value is unchanged.

In many ways, stock splits are purely psychological. They don’t change a company’s total value or the value of your investment. They do change perception. A lower stock price can make a stock feel more affordable and may attract new investors. These moves don’t change the fundamentals. Earnings, growth, and financial health determine the value of a company or the size of the pie. Stay focused and plan accordingly.