Rule #1 Finance Blog

With Investor Phil Town

THE STOCK SPLIT GAME

Starbucks just announced it’s going to split its stock 2 for 1 at the end of the month. What is going to happen to the stock price? Nothing actually, although it’s going to look like something big happened. Stock splits don’t change the market cap or the sticker price (which we know are often different) one single cent. Not a penny. All a stock split does is change the number of shares and the price per share. I repeat: this does not change the the total value of all those shares by even one cent.

Let’s say Starbucks is selling for $50 on the day of the announced split. The $50 per share means that Starbucks is being priced by Mr. Market a total price of $50 times all the shares that are out there. Since Starbucks has about 400 million shares that are owned by investors, the market cap of Starbucks on that day would be about $20 billion.

After trading finishes that day, the accountants at Starbucks issue two new shares of Starbucks stock to every shareholder in exchange for one of the old shares. The business suddenly no longer has 400 million shares. It now has 800 million shares. Nothing magic has happened. All that happened is that they took away the old 400 million shares and issued 800 million shares as a replacement. Did the value of Starbucks change? No. Did the market suddenly reprice each share of Starbucks because they now have a whole lot more stock out there? Yes.

The next trading day, the market price of Starbucks will be something right around $25 per share. The reason that the price gets cut in half is that the value of the business didn’t change at all just because the management split the stock. Therefore, if the business is still worth $20 billion, the price per share has to be half of what it was before the split in order to not suddenly have the total market cap (market price of the stock that day times all the shares) go up or down. Since a stock split doesn’t change the business at all, all that happens is the price changes per share to adjust for the new shares that are out there.

So why, if splitting the stock doesn’t change the market cap or the value of the business by even one cent, does the CEO of Starbucks bother to play this little accounting game? For one and only one reason: A lower stock price makes it easier to trade. Lower prices make it easier to find buyers than higher prices.

When a stock price gets over $100 a share, people start to think of it as ‘expensive’ even though the price of the stock has nothing to do whatsoever with the actual market cap of the business. A business worth $1 million is worth $1 million whether there is one share worth $1 million or 1000 shares worth $1000 each or 1 million shares worth $1 each.

But how many buyers are there out there for a single share of stock worth $1 million? Not very many. Let’s say there was one buyer. The owner of that single share might have to take a much lower offer simply because there is only one buyer. But if there were a million shares at a $1, there can be lots of buyers: Big guys who are buying it up in little pieces or little guys who just want 100 shares. Lower stock prices make for more trading. And often, more trading makes for higher stock prices.

Warren Buffett knows this. Mr. Buffett does not want trading in Berkshire Hathaway shares. He would prefer his shareholders never sell a single share. To discourage trading in BRK, Mr. Buffett has steadfastly refused to split the stock ever. He thinks that helps keep the price of BRK close to its value.

Starbucks is splitting its stock because the CEO of Starbucks wants the stock to be priced as high as he can get it priced by the market as opposed to being priced at about what it’s worth. Getting a company’s stock up is important to most CEO’s because of misguided incentive programs, option trading pressures and fund managers who want short term success, none of which have a single thing to do with improving the Sticker Price of the business. But that’s the way most of Wall Street works so most CEO’s bow to pressure and split their stock.

Bottom line on stock splits: It’s a game. Don’t take it too seriously.

Now go play.

Phil

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Phil Town is an investment advisor, hedge fund manager, 3x NY Times Best-Selling Author, ex-Grand Canyon river guide, and former Lieutenant in the US Army Special Forces. He and his wife, Melissa, share a passion for horses, polo, and eventing. Phil’s goal is to help you learn how to invest and achieve financial independence.