Research - Stock Splits, Stock Splits
A deep dive into stock splits: what are stock splits and why do companies do it?
This will be a short research article since I’ve been a busy bee. Nonetheless, I hope readers still find this helpful and informative.
Three large cap tech companies have announced (or performed) stock splits in the past 2 years: Apple (4-for-1 in August 2020), Alphabet (20-for-1, announced in February), and most recently Amazon (20-for-1, announced Tuesday). This article will tackle what stock splits are, and why companies would do it.
How Do They Work?
A company is worth a certain dollar value, determined by the market. This is its market cap. To trade on public markets, the company splits its ownership into shares. Owning a share means owning a percentage of the company, dependent on how many outstanding shares there are. For example, if Company A has a market cap of $1,000,000 and has 1,000 shares, each share is worth $1,000.
A stock split fundamentally increases the number of outstanding shares of the company. For example, if Company A with 1,000 outstanding shares decided to do a 20-for-1 stock split, then it would now have 20,000 outstanding shares. But the value of the company shouldn’t change since its fundamentals didn’t change. As such, the market cap holds steady and each share is now worth 20x less ($50).
But what about existing shareholders? Because a stock split affects every outstanding share, existing shareholders will receive 20x more shares (using the above example), no matter the state of the shares (e.g. unvested RSUs). However, the total value of these shares should remain the same given that the price of every share is divided by the split ratio.
What about outstanding options contracts? An options contract controls 100 shares of a company. When a stock split occurs prior to contract expiry, the Options Clearing Corporation (OCC) will adjust the number of shares controlled by the contract and its strike price. For example, at a 20-for-1 split ratio, affected contracts would be updated to control 2,000 shares instead of 100 and strike prices will be divided by 20.
Stock splits seem to do nothing but increase the number of outstanding shares and decrease price per share… so why do companies do it? Let’s find out.
The DOW and the Structural Bid
Most of us have heard about the Dow (Dow Jones Industrial Average). It’s one of the oldest and most popular stock market indices that many use to gauge the overall performance of the stock market. Fun fact: the Dow was founded 137 years ago in 1885!
Due to its early founding, the Dow uses an archaic price-weighted way to construct the index, rather than the current and more sensible paradigm of using market caps. The former calculates the value of the index based on the share prices of the index’s constituent companies, while the latter calculates the value of the index based on the market caps of its constituent companies.
Price-weighted index construction is generally considered ineffective and bordering on nonsensical, given that share prices are determined by how many shares a company issues, rather than the company’s actual worth. Alas, due to the Dow’s long history, it has become an integral part of a contemporary stock trader’s vernacular.
There are 30 companies in the Dow. Since the index is price-weighted, the prices of each company’s shares matter. This is partly why Alphabet and Amazon are not included in the Dow, even though they form such an integral part of the US stock market and economy. With share prices of over $2,500, they would jarringly impact the Dow’s value if they were included. However, if the share prices were significantly lower (i.e. from a stock split), then there would be more appetite to include them in the Dow. The possibility of being included in the Dow is perhaps why Alphabet and Amazon chose the 20-for-1 ratio, which makes their share prices more inline with the share prices of current Dow companies.
Being in the Dow has several benefits. Besides the prestige of being in such a historical and fundamental US stock market index, more importantly it also means that the many ETFs and mutual funds tracking the Dow need to include the company’s stock in their holdings. This increases buying interest and liquidity in the company’s stock. In other words, inclusion in the Dow strengthens the structural bid of the stock.
Structural bid is a term that many equity analysts have started using in the past decade or so. It basically describes the fundamental buying pressure of a stock no matter the conditions of the broader market. This is brought forth particularly by the proliferation of ETFs and mutual funds, such as for retirement investing, in the past couple decades. The best example of this is the fact that a portion of most US pay checks is now directed by default to a 401k retirement fund that is obligated to buy into the market, and often into ETFs and mutual funds tracking the Dow.
Put simply, the more exposure a stock has to broad market index funds, the stronger its structural bid. You can see this in action in the recent market drawdown where anything but the large caps were basically decimated (SQ down 60% from 2021 highs, SHOP down 70% from 2021 highs).
More Liquidity
Stock splits lower stock prices, and a lower stock price tends to increase a stock’s liquidity (i.e. trading interest in a stock). More liquidity generally makes a stock’s price more stable.
This is the case for a couple reasons.
First, it’s much less intimidating to purchase a cheap stock than an expensive one. Buying a $20 stock feels like buying dinner, while buying a $3,000 stock feels like buying a used car. One could argue that this shouldn’t matter now given the widespread availability of fractional shares but even then, I’d argue that the feeling of owning a whole share is better than owning 0.7% of a share. It doesn’t make sense financially, and is mostly psychological, but still impactful (think Dogecoin or Shiba Inu coin). The positive psychological effect of cheap shares should only affect retail traders but retail traders collectively generate a significant portion of the stock market’s trading volume.
The second reason why a lower stock price increases a stock’s liquidity is its outsized impact on options trading, which has become widely popular in recent years. As mentioned above, an options contract controls 100 shares of a company. They are priced based on a percentage of a share’s price, multiplied by 100. So the more expensive a stock is, the more expensive its options contracts are. In addition, traders that want to sell covered calls or cash secured puts (two popular ways to trade options) need to own at least 100 shares or own enough money to purchase 100 shares. As such, a lower stock price enables a lot more options trading, which through complex market mechanics, also increases the trading of the underlying stock.
The more a stock is traded, the higher its liquidity, and theoretically, the more stable its price is. Companies love stable and upward trending stock prices.
Compensation Flexibility
Finally, another nice perk of a lower stock price, especially for companies that rely heavily on stock-based compensation (* cough cough * FAANG), is compensation flexibility. Specifically, a lower stock price gives a company much better resolution and fine tuning when determining stock-based compensation. For example, instead of deciding compensation based on $3,000 increments, after a 20-for-1 stock split, the company can decide compensation with $150 increments. The increased compensation efficiency is a minor perk, but still notable.
Aside: Buybacks
This is not related to stock splits, but I still wanted to touch on buybacks given that Amazon recently announced a $10B buyback program in tandem with its 20-for-1 stock split.
When a public company generates profits, its job is typically to return that value to shareholders, or else why would the shareholders own the company? There are a few ways to do this but the two most tax efficient (i.e. zero taxes) ways are to buyback shares or invest the profits back into the company. The latter might be easy to understand, the former is more opaque. Buybacks are essentially a way for companies to shrink the overall number of outstanding shares by buying back these shares from the open market. While the company’s market cap should remain the same, its number of outstanding shares is reduced, thus increasing the price per share of all the remaining shares and making existing shareholders wealthier.
Buyback plans, when announced, are not immediately enacted. For example, a $10 billion buyback plan doesn’t mean the company will immediately start buying back $10 billion worth of shares from the market. Instead, the company is authorized to buyback this value of shares and it can do so slowly overtime, at any time based on the CFO’s discretion.
Buybacks form another integral part of a company’s structural bid.
The impact of buybacks can be significant, especially if a company is committed to it. Take Apple for example, which has reduced its outstanding shares by about 40% since 2013. Amazon, on the other hand, tends to reinvest its profits and has increased its outstanding shares by 11% since 2013.