Why Stock Splits Aren’t as Important as You Think They Are

Maybe you’ve heard this before… “I wanna buy XYZ stock because it’s going to split and I’ll have more shares.”

Stock splits are pretty popular right now. Tesla is splitting their shares 5-for-1. Apple just announced a 4-for-1 split. And the above statement is correct: you will have more shares. But does a stock split add any value? Some people seem to get excited about a stock split — like they’re getting something for free — but like many “free” things in life, they aren’t all they’re cracked up to be.

So What is a Stock Split?

It’s a transaction whereby you might have 5 times more shares, like in the case of Tesla. But the price of your stock will drop by the same amount. If I have 100 shares of stock at $10 a share and it splits 5 to 1, I now have 500 shares at $2 a share. My ownership of said stock stayed exactly the same.

“But a stock split creates more liquidity and stirs excitement around the stock'” you say. It might. There are some studies that show in the short run a split does create talk around a company and adds liquidity.

Berkshire Hathaway is one stock that famously never split their shares. The “A” shares traded well over $100,000 each before Berkshire added the second “B” share class in 1996. When asked about it, Buffett responded with a lengthy but well thought out answer.

“Well, first of all you must understand that a stock split is merely a cosmetic transaction. Our shareholders are no better off after a stock split than before. Also a stock split doesn’t occur for free. There are investment bankers to pay and filing fees, etc. The stock doesn’t magically split itself. There are a myriad of fees and expenses to pay to complete the transaction. It just doesn’t seem like an intelligent way to allocate our capital.”

—Warren Buffet, Berkshire Hathaway

The fact is original shareholders did just fine without the split. From 1965 to 1995 Berkshire shares compounded at a 25% annual rate. “I want the shares to be in strong hands. I don’t want it to be a trading vehicle for someone who doesn’t know what we are about or what we do.” Buffett wanted long-term thoughtful shareholders. By never splitting the shares Buffett scared off the wrong type of shareholder. That’s actually pretty smart if you’re trying to build something.      

However in 1996 Berkshire bought Burlington Northern using it’s own stock as currency. In order to pay all the stockholders of BNSF, Berkshire had to issue B shares. Berkshire’s A shares were too large to divide up to Burlington’s stockholders so they issued new ones. So, yes a stock split can definitely help with liquidity.

How Simple Math Can Be Misleading When it Comes to Stock Splits

A $10 stock sounds cheaper than a $100 stock. (And if you think that, you definitely shouldn’t be investing on your own). But the reality is stock price alone is totally meaningless. A $10 stock might be more expensive than its $100 brethren. That’s because all stocks are put together differently. Our $10 shares might have billions of shares outstanding. Our $100 stock might have only a couple million. So the $100 stock would be a much smaller company in this case. Its stock might be really cheap at $100 because you’re buying a greater percentage of the company.

In the old days, buying a $10 stock was less costly than buying a $100 stock. You had trading costs. And trading costs could be expensive. Splitting the stock could reduce the trading costs. But today you can buy stock for free on almost all platforms. Trading costs have been driven to nearly zero. So that’s no longer applicable.

Apple shares have increased since it’s 7-for-1 stock split in 2014. But this was driven by an increase in earnings and an expansion in the multiple investors are willing to pay. Both are ways stocks go up. The earnings increase makes sense you say, but what is the multiple expansion all about?

Well, in 2014 investors were only willing to pay 12 times the net profits Apple made to buy a share of stock. Today they’re excited, so they’re willing to pay more than 12 times earnings. Today they’re willing to pay 22 times profits or almost double 6 years ago. The multiple has expanded from 12 to 22.

The Apple stock split in 2014 was really irrelevant to making money for shareholders. The underlying business has performed very well. Which reiterates my point. There really is no correlation between stock splits and stock price performance going forward.  A stock split might sound great but you really must look under the hood to understand if it’s a great investment.

Looking under the hood and asking questions few others ask is what sets apart CSH Investments from other financial advisors. If you read a news story about how Tesla is splitting stocks, and you are wondering if that approach is right for you, we encourage you to email us or give us a call before making a decision. Oftentimes, news stories don’t have the time to adequately cover a topic, and may even hold biases that could thwart your goals. Everyone deserves a reliable financial partner they can trust and openly communicate with. We hope to be that for our clients. Please give us a call at 217-824-4211 if we can help.