Stock splits have been around for a while but they recently gained attention after announcements from high profile companies. You have shares, you hear about it and you start to wonder what will happen after the split?
The answer is not much. I assume you already know how stocks work so we’ll move on to market capitalisation.
What is market capitalisation
Market cap is basically how much will I need to pay to purchase the whole company. This includes the stake of the CEO, managers, etc.
When you look at share statistics you’ll find two terms outstanding shares and free float or simply float.
Outstanding shares include all stock which is currently in existence. If you multiply the number by the share price you’ll get the intraday market cap.
Free float on the other hand reflects the number of shares which are available to the public. This number will be smaller than the outstanding shares.
Outstanding shares – Free float = Restricted stock or the owners’ stock
Owners’ stock is a too simplistic explanation
We also have managers, directors, staff stock options and so on.
Authorised shares is the amount of stock a company can ever issue. If it wants to issue more you will need to get approval from the shareholders. A company may have 5 million outstanding shares but the authorised shares could be 20million.
So I lacked the foresight to authorise more than 10 shares and now my 3 shareholders voted against me and I can’t sell more. Thankfully listed companies have thought about this in advance.
Restricted stock is the one which is distributed to directors and managers or already owned by the CEO. As the name suggests they can’t just sell it as they please. Any sale has to comply with the relevant regulation.
Where does the restricted stock come from
Managers come and go so you may start thinking that the company will keep printing shares until yours are worthless.
Don’t worry it comes from the firm’s treasury. These shares are purchased from the open market during a stock buy back for example.
Remember that only a portion of the company is offered for floatation during an IPO. Therefore, the CEO, some of the managers and early stage investors already own a lot of shares.
What is a stock split
It just means that the company is slicing each share in smaller bits. A 5 for 1 stock split means that you’ll have 5 shares instead of 1.
The market cap of the company won’t change, it will just have more shares.
Why companies organise stock splits
There are a few reasons and we’ll go through all of them. We’ll start with the good ones.
The shares become more affordable for investors. It may seem that it doesn’t matter if you’d buy 10 shares for £100 or 1 for £100 but it does. And I mean a lot.
For example, I trade options and I don’t trade companies like Amazon, Google, Tesla or even Spotify because they are too expensive. I can get better value for money from $50 stocks. I don’t care that much what I trade so I stick with the cheaper ones.
When you buy 10 shares or 1,000 you can take some profits if the price goes up. You bought 1k shares for $3 each and if the stock goes up to $10 you can sell 500 of them to realise 67% profit. But you also keep the rest to make even more money. How are you going to do that with 1 Amazon share?
The more shares there are the more volume.
A $7-8 stock like General Electric easily reaches a daily volume of 30 million on a bad day.
Berkshire Hathaway’s class A shares rarely trade a volume of 1,000. I wasn’t surprised considering the cost of $311,500 per share. No wonder they have the class B shares which are priced around $200 and change hands in the millions.
Liquidity is very important, it just makes the market more efficient and you feel more confident that you are paying a fair price. How do I know that the price is fair if only 2 investors traded a stock last week?
This is what happens when you trade stock which is not very liquid:
Someone dumped 2x the daily volume in 15 minutes and the price dropped 1.5%. The volatility of the stock spiked too so it took 3 days for my position to recover. Am I trading that again? Probably not unless the offer is really good.
Can this happen to a stock with a daily volume of 50 million? Maybe but not over the sale of 500k shares.
Agency theory refers to the principal – agent relationship in a listed company. The separation of ownership and management creates this because the managers act as agents for the principal which is the shareholder.
It sounds really good on paper because you as a shareholder hire people who are better at running the company. You just pay them and collect the profit which is expected to increase due to the agents’ skills.
In reality the situation is slightly different because your interests and the agents’ interests are rarely aligned. They may vote to pay themselves bonuses of 10 million each and there is nothing you can do unless you have majority voting rights.
Ideal scenario for the top management team
This is obvious, if I’m a manager I’d want 5 billion shareholders and I want each of them to own just 1 share which has 1 vote.
I will be able to do as I please because it will be really difficult for them to gang up against me and vote me out. As you’d imagine I’ll get a private jet and all the other bells and whistles.
The nightmare scenario: a hostile takeover
Let’s assume that a company has 1.1 million outstanding shares and the free float is 1 million. There is only one class of shares and each of them has 1 vote.
I’ll have majority voting rights if I manage to purchase 600k shares from the market. Then I’ll go to the office and I’ll be able to do anything I want within reason and assuming I abide by any legal restrictions.
Do you think the top management team would like that? Me neither.
That’s why some companies hold a larger treasury stock or they have classes of shares which have more votes. A Facebook class B share has 10 votes while a class A has 1. You may not be surprised that each class B share is converted to class A upon sale to the public.
Purpose of the stock split
I think that it is clear that it is meant to disperse shareholders. This is not necessarily a bad thing because small investors like you and I can’t buy a controlling stake anyway.
However, we benefit from the improved affordability and liquidity. The verdict is bring the stock split on.
What happens to my shares
Nothing, you’ll just have more of them. The company will announce a day when the split is happening and the stock will start trading for the new price.
For example Apple announced that their latest stock split is taking effect on Friday the 28th of August 2020. The stock started to trade for the new price on the following Monday.
Am I going to get diluted
No you’re not. You’ll be diluted only when new shares are issued.
The most frequent event which causes this are stock options which are granted to employees and later exercised. However, the option pool should have been sorted out before the company went public. It is usually investor friendly but you can always dig in company reports to find out.
Another one is a secondary offering like a rights issue for example. These happen when the company wants to raise additional capital.
Finally, it can also happen during an acquisition if new shares are offered to the shareholders of the company which is being bought.
The only way to protect yourself is to examine the firm’s financials to make sure it has enough money and won’t need any new capital anytime soon.
When am I getting the extra shares
This depends on your broker so just email them to ask if you hear about a stock split.
You may not be getting the stock on the day of the split because it could take a few days to organise everything. I think that it will be extremely unlikely to experience any issues as long as you are using a reputable broker.
If you’ve contacted them and it’s been too long without any results you may need to get in touch with the regulator in your jurisdiction.
What is a reverse stock split
This time you just get less shares. If we go back to the 5 for 1 stock split the reverse will be 1 for 5. You’ll get 1 share for each 5 shares that you own. Bear in mind that there will be a way you are compensated if you have an odd lot (like 13) so check the terms and conditions.
A reverse stock split actually can be a bad thing. It is common for inverse leveraged ETFs like SQQQ which is 3x short the Nasdaq 100. The Nasdaq had an amazing run this year so SQQQ went down to $6 or $7 at some point.
You don’t want shares that cost $300,000 each but you don’t want ones which are $0.10 either. Let’s face it, a company which is trading for $1 is a penny stock.
I’ve got some UK shares and quite frankly it puts me off investing when I see stock priced at 25p. I mean how much upside is there in something that costs less than chewing gum.
Overall, the company is trying to remain relevant, to attract some investors, to satisfy listing requirements or is being restructured. The only case when this is normal is an inverse fund because the market has a positive drift and these constantly lose money.
Stock split summary
A stock split shouldn’t frighten you, on the contrary, you’ll have more shares so you can lock in some profits.
There’s nothing special to look out for, just check with your broker when you’ll get your shares. Don’t worry if you see a loss, it may be just a glitch on your platform until they sort out the software.
You won’t get diluted even if it is a reverse split. However, this version raises questions about the company’s future. It’s important to do your research and figure out if it’s time to get out.
Affordability and liquidity are always good, especially for small time investors.
I wouldn’t be worried about any agency problems unless you invested your whole pension in a single stock. I hope that you didn’t.