Fool's Eye View

[ December 2, 1999 ]

Splitting Headaches

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- A little while ago I wrote an article for our Growth Investing area about stock splits. Many investors get very excited about stock splits and some seems to think that this is a sure fire way of making money. Recently, in an investment club that I am involved in, I ended up having a heated argument with a number of the other members (there is nothing new about that!) who said that stock splits enhance an individual's wealth. No matter what I said, I could not persuade them otherwise. At the same time we were considering buying some shares in Baltimore Technology (LSE: BLM), whose share price is currently about £30. One of the club members asked if they were likely to split their shares soon, and if they were would it not be better for us to wait until they have split before we bought as we would then get more shares which would be better, wouldn't it?

Many investors are fixated on the share price, and what I want to try to say today is that THE SHARE PRICE DOES NOT MATTER! Neither does the number of shares that you actually own. There -- I have got that off my chest. Now, I must try and explain what I mean. The price of a listed company is determined by its market capitalisation, not by its share price. The market capitalisation is a function of two things, and only two things. The first is the number of shares in issue and the second is the share price. Multiply the two figures together and you will have the company's market capitalisation. From this it should be obvious that if a company is valued at £50 million then it makes no difference if that value is arrived at by having 1 million shares each valued at £50 or 50 million shares each valued at £1. The eventual market capitalisation is exactly the same.

I often hear it stated that it would be better to buy the company with the shares valued at £1 rather than the company with shares valued at £50. The theory is that will be easier for the shares valued at £1 to double to £2 than the £50 shares to double to £100. This is of course complete and utter bunk. It makes no difference, in both cases the total value of the company has to double for the share price to double, and the likelihood of that happening is exactly the same for the company no matter what its share price actually is.

I know that many Fools will still not agree with me, but let's try and tackle this from a different direction. Imagine that you have a £50 note, you want to buy some sweets, but you know that you local corner shop won't have enough change: so you decide that you want to split this note up. You go into the bank and get a £20 note, a £10 note and £20 in pound coins. You have split the £50 note up, but you still have £50, just because you have now got more notes and coins you still have £50. It won't buy you any more than before, so spitting up the note has made no difference to the value of the money that you had. It is exactly the same with shares. If a company splits its share price the value of your investment stays EXACTLY the same!

The important thing for all Fools to recognise is that companies split their shares as their market capitalisation grows; splitting the shares does not cause the market capitalisation to grow.

Having said that... there does seems to be some evidence that over the short term when a company splits its shares the share price does improve. By short term I mean a few days -- and often after the split has been announced, but before it has actually happened.

OK, I now seem to be contradicting myself, don't I? On the one hand I say that stock splits make not one jot of difference to the future performance of the share price, and yet on the other hand there does appear to be some anecdotal evidence that when a stock split happens the share price rises. Rationally this shouldn't happen, but that's what makes it a market -- if enough people believe that a split is going to make the share price increase, and they back up this belief by buying the shares, then the share price will increase. It's a self-fulfilling prophecy based on investor perceptions. But this effect is only short term and temporary.

There is also some anecdotal evidence that says when a company splits its share price, over a longer term the share price often soon gets back to where it was 'pre-split'. Mmm -- I seem to be contradicting myself yet again! But let's look at this logically.

Why will a company usually split its shares? Well, it is certain that some companies recognise that when the share price gets 'high' relative to other companies' share prices then some investors start to worry about the share price. OK, I have said that in theory it makes no difference, but in practice (and we operate in a market after all) many investors don't like buying small numbers of shares at high prices. But the right question to ask is "why has the share price increased to a high level?" Usually it is because the company has been performing well, producing increasing profits and growing the business. This leads to more people wanting to buy the shares and so an increase in price. When a company splits its shares it has not changed anything else in its business. We know that winning companies very often continue to be winning companies, so it is very likely that the company will continue to perform well in the future, increasing its profits and growing its business; this continues to attract investors and so pushes the share price up.

The act of splitting shares does not generate more wealth, and certainly does not change the business one bit. Stock splits do not lead to increasing share prices over the long term. Improving company performance and investor perception leads to an increased share price -- over the long term -- which may lead to a stock split. After the stock split the company may continue to perform well, increasing profits and growing the business which may lead to increased investor interest, which in turn leads to increased share prices, and possibly another stock split. But the stock split is the result of improved company performance and an increasing share price -- it is not the cause of the increasing share price!

Having said that, looking for companies that have recently split their shares, or have announced a split in the share price, can be a sensible way of finding shares that may be worth looking at in more detail. Very often these will be companies that have demonstrated long term growth, but once you have identified a company in this way, do your own Foolish research and make your own investment decision based on the performance of the company and the prospects that you see for it. Never buy shares in a company simply because it has split!

If you don't agree with me please do give some feedback on the Fool's Eye View message board, but be prepared for some combative responses if you don't believe me!

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