IntroductionThe purpose of this research paper is information retrieval regarding stock split practice in a modern stock market, its major reasons and valuation effects on the company’s financial position. According to the definition stock split is a method commonly used to lower the market price of a firm’s stock by increasing the number of shares belonging to each shareholder. Companies are able to split their stocks in any number of ways.
The most common stock splits are, 2-for-1, 3-for-2 and 3-for-1. For example, if you own 100 shares of a company that trades at $100 a share and it declares a 2-for-1 stock split, you will own a total of 200 shares at $50 a share after the split. It is also possible to have a reverse stock split: a 1-for-10 means that for every ten shares you own, you get one share. In spite of the fact that theoretically stock split has insignificant effect on the firm’s capital structure and value of what shareholders own, many companies consider carrying out this corporate action. Let’s take a look at the real world examples and find out the actual motivations of this tendency. Regular Stock Split
Macy’s, IncOn May 19, 2006, the Macy’s, Inc. board of directors approved a two-for-one stock split of Macy’s, Inc. common stock. June 12, 2006 Macy’s, Inc. common shares traded on NYSE at the new split-adjusted price, reflecting the doubling of the number of outstanding shares. It was the first stock split since Macy’s, Inc. was listed in its current form on the New York Stock Exchange in February 1992. The split is structured in the form of a 100% stock dividend, payable June 9, 2006 to shareholders of record on May 26, 2006.
As a result of the stock split, each shareholder received one additional share of common stock for each share of common stock owned as of the close of business on the record date, at half the market price per share. For example, if an investor owns 100 shares of FD as of the record date and the market price is $74.00/share, that investor’s total value is $7,400.00. After the split, the investor will have a total of 200 shares of stock, but the market price will be $37.00/share. The investor’s total investment value in FD remains the same at $7,400.00 until the stock price moves up or down.
After the stock split the proportionate vote and interest a stockholder maintains in Macy’s Inc. remained the same relative to other shareholders. The par value didn’t change and stayed at $0.01 per share while quarterly dividend was 12.75 cents per outstanding common share. There was no cost to stockholders in connection with the stock split and they did not have to pay taxes on their receipt of new shares. In order to analyze influence on the company’s financial position on the market let’s take a look at the numbers. The table 1 provides information for 2006.
Table 1As we can see, in the second quarter of 2006 close price adjusted for dividends and splits had a tendency to go down (from 42.69 to 34.51), but after the 2:1 stock split it became to increase (from 35.98 to 38.12). However, at the end of the year the close price went down to 32.37. In order to analyze this situation lets take a look at the theoretical and practical sides of stock split situation, its economic reasons and possible results. As we know from Law of Demand, there is a negative or inverse relationship between price and quantity demand.
After stock split in the second quarter 2006 the price of each stock decreased of half market price and become more affordable for the larger amount of investors. As a result, the number of Macy’s Inc common share buyers increases, which moved the curve of the demand of Macy’s Inc common share up (table 2). The increase in demand leaded the price of the stock to move up and we can see the results of it in the previous table 1. Table 2. Supply and Demand of Macy’s Inc common share
P price per shareQ – quantity of shareS – supplyD – demand
Theoretically, a stock split is commonly done by companies that feel its per-share price has risen beyond what an individual investor is willing to pay. They believe that lowering the market price will make their stocks more affordable for these investors and thereby stimulate and increase trading activity. However, the low price is not the guaranty of success.
For instance, there are many cheep stocks at the market, which nobody wants to buy because there is no potential of these companies. Another economic reason why company might do a stock split is its optimism about the future. Eventually the stock split causes an increase in the numbers of shares on the market, which lead to decreasing of Earning Per Share (EPS). It is normal for EPS to decline after stock split because EPS = Net Income/ Total of shares outstanding. Since Net Income will not be impacted by the stock split, EPS has to go down due to increase in amount of shares outstanding.
However, if the company has good expectations about their financial future, it might not be too concern about decline in EPS. In the practice we can see that the theory works and summation of increasing numbers of investors willing to buy the stocks and underline company’s signal of its optimistic view at the future lead to increasing of Macy’s common share’s price. However, we can assume that Macy’s positive prognoses about the future are not completely proved in reality and price eventually went down. Again, it provides evidence that price is not the key point of buying decision.
The main factor, which stimulates investors to purchase the stocks, is their expectation of increasing company’s future profitability. In order to prove this point, let’s take a look at the history of Berkshire Hathaway Inc, which has an extremely high price per share. For example, one year ago a single share of Berkshire Hathaway cost around $101,000 per share and was the first stock to ever hit a six-digit share price.
Berkshire Hathaway is not going to split their stocks and not interesting to make the price more affordable for small investors because these stocks are not for common people. These stocks are designed for very wealthy investors. As we can see from Figure 1, through one year the price of Berkshire Hathaway’s shares increase for approximately 48,000 per share. Figure 1. BRK-A, 2007.
Thus, in spite of fact that price of these stocks is awfully high, investors still buy it because it has been increasing from year to year. Reverse Stock Split A reverse split reduces the number of outstanding shares and should instantly lift a stock’s price. For example, a stock trading at $1 that is reverse split 1-for-5 should rise to $5 while the company’s market value and underlying fundamentals are unchanged. Investors own fewer shares, but their value stays the same. So, it really depends on the substance of the stock behind the stock. And it is right that most reverse splits turn out badly.
Most times, a reverse split is done because the shares have fallen down into the penny stock category (below $5 per share) that threatens their ability to remain listed on an exchange. Nasdaq requires that a company maintain a minimum stock price usually $1 a share or be delisted. Delisted stocks are banished from major exchanges and relegated to over-the-counter “pink sheets,” where it is difficult to attract large investors. Usually when they’ve fallen that low in price it is because there’s no substance behind the story, so it’s already trading purely on hope.
For companies like that, a reverse split is usually a disaster, because there’s nothing (such as earnings) to hold the shares up to a higher price and they usually fall back to the original price within months. So, you end up with the same worthless stock with fewer shares. If, however, the company has substance (earnings, etc.) behind the stock, a reverse split can be a good thing. Priceline.com would be a good example of the company for which reverse stock split worked well in recent years. Priceline, Inc
Priceline.com, Inc operates as an online travel company in the United States and Europe. It offers its services under the Name Your Own Price’ brand, which allows its customers to make offers for travel services at discounted prices. The company provides various travel services, including airline tickets, hotel rooms, car rentals, vacation packages, cruises, destination services, and travel Insurance.
It also sells advertising to travel suppliers and others on its Web sites. In addition, the company provides various financial services, including mortgages, home equity loans, and banking, through its investment in Priceline Mortgage Company LLC, doing business as, pricelinemortgage.com. priceline.com was founded in 1997 and is headquartered in Norwalk, Connecticut.
On June 16, 2003 Priceline.com Inc (Nasdaq: PCLN) announced that it had effected a 1-for-6 reverse stock split of all outstanding shares of its common stock, par value $0.008 per share. As a result of the reverse stock split, each priceline.com stockholder received 1 new share of priceline.com common stock in exchange for every 6 old shares. The following table provides change in price per share of stock from May, 2003 to May, 2004. PRICES
DateOpenHighLowCloseAvg VolAdj Close*May-0424.3127.2422.2726.20941,10026.20Apr-0427.0727.7423.8324.27732,20024.27Mar-0423.3027.5821.9026.96997,30026.96Feb-0419.3025.6518.2823.021,878,50023.02Jan-0418.0521.7218.0019.131,169,10019.13Dec-0319.2419.3016.1217.90954,80017.90Nov-0328.3030.1017.1219.052,744,70019.05Oct-0329.1834.0026.6628.18827,60028.18Sep-0339.7039.7227.4429.041,214,00029.04Aug-0332.8339.8129.1839.49803,20039.49Jul-0322.4135.4421.3232.841,333,50032.8416-Jun-031 : 6 Stock SplitJun-034.1825.913.5922.322,724,10022.32May-034.354.374.074.106,022,20024.60* Close price adjusted for dividends and splits.
The table shows that their stock after the split did relatively well, even though reverse splits generally tend to have the reverse effect and stocks that do reverse splits often tend to decline after the split is announced or completed. Some investors even call reverse stock split “a kiss of death”. Priceline.com’s stock did well only due to their earnings. (Figure 2) On November, 4 2003 Priceline.com reported third quarter 2003 net income of $9.7 million, or $0.24 per share, on revenues of $243.4 million. Net income applicable to common stockholders was $0.21 per share inclusive of a non-cash preferred stock dividend of $1.2 million.
Priceline.com’s net income of $0.24 per share exceeded First Call analyst consensus of $0.21 per share and came in ahead of priceline.com’s previously announced target range of $0.20 to $0.22 per share. Gross travel bookings, which refers to the total dollar value, inclusive of taxes and fees, of all travel products purchased by consumers, were $300.5 million for the 3 rd quarter, up 9% compared to 3 rd quarter 2002.
Priceline.com reported that, during the 3 rd quarter 2003 it sold a record 1.6 million hotel room nights, representing a 41 percent increase over the same period a year ago and a record 1.1 million rental car days, representing a 43 percent year-over-year increase.
ConclusionFrom the previous examples we can see that a regular stock split is commonly done by companies that want to lower their stock price. It is done to encourage small investors to participate in the particular stock. Small investors can invest in stocks with affordable price. Reverse stock split, on the other hand, are done to increase stock price. By increasing the stock price reverse splits can help potential buyers to purchase the stock. The increase in share price also helps change the market’s perception of the stock as it becomes less of a “penny stock”.
The improvement of market perception should make the stock more acceptable to institutional investors because they are concerned about the justification of their stock selection. In addition, reverse splits move the share price towards some desired range and, therefore, improve the marketability of the stock. Stock split by itself changes nothing. The main idea behind it is to make your stock more attractive to investors.
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