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investor clinic

I read that Netflix is splitting its stock seven-for-one. What is the purpose of a stock split, and is this a good time to buy Netflix?

Companies split their shares for a couple of reasons. First, a split is intended to make the shares more attractive to retail investors. For example, many investors like to purchase shares in multiples of 100 – there's no reason they have to buy a "board lot," but it's an old habit that has stuck – and a lower stock price makes it easier to do that.

Second, the larger number of shares increases the volume and liquidity of the stock, which facilitates trading without causing undue volatility in the price (not that Netflix, which often trades several million shares a day, isn't liquid enough already).

It's important to understand that a stock split, in and of itself, doesn't create any economic value. In Netflix's case, after the split – which is effective on July 15 – investors will have seven times as many shares, but each share will, all else being equal, trade for one-seventh of the pre-split price. So the value of their investment won't change.

However, research has shown that stock splits do provide clues about the future direction of share prices.

In a 1996 study, David Ikenberry (then of Rice University in Houston, and now based at the University of Colorado, Boulder) examined more than 1,000 U.S. companies that split their shares between 1975 and 1990. He then compared them with companies that did not split. The result: The splitters outperformed the non-splitters by eight percentage points after one year, and by 16 percentage points after three years.

Stock splits may also have predictive value when it comes to earnings. According to a 2003 study of Canadian stocks from 1977 to 1993 by Said Elfakhani of American University of Beirut and Trevor Lung of San Diego-based First National Home Finance, "it appears that earnings grow in the two-year period following split events, thus implying that split events signal future performance of the firm."

None of this proves that stock splits, per se, cause earnings and share prices to rise. A more plausible explanation is that companies that announce stock splits tend to be performing well already; their earnings and share prices were probably rising before the split, and they often continue to rise after the split.

One high-profile example is Apple, whose shares are up about 75 per cent – including dividends – since it announced a seven-for-one split in April of last year. Apple's revenue, earnings and dividends have also been rising during that time, so one would expect the stock to have gained whether it had split last year or not. However, it's possible that Apple's lower post-split share price may have created more investor demand that contributed, at least in a small way, to those gains.

Will Netflix follow Apple's lead? Although Netflix and Apple have a seven-for-one split in common, they are otherwise very different companies. Netflix doesn't pay a dividend, it's far less profitable than Apple and it trades at a sky-high multiple of about 200 times estimated 2016 earnings, compared with a much more reasonable 2016 multiple of about 13 for Apple.

So, while stock splits often signal good things for companies, Netflix will eventually have to deliver some impressive earnings growth to justify its astronomical price-to-earnings multiple. And that would be true whether Netflix had announced a split or not.

It's worth noting that Netflix's shares initially popped after Tuesday's split announcement, but have fallen for the past three sessions. News of the split also came shortly before billionaire investor Carl Icahn disclosed that he had sold the last of his Netflix shares – not exactly a bullish sign for the video-streaming giant.

Netflix isn't the sort of stock I would buy – it trades mainly on momentum and its valuation bears little relation to reality – but then, Netflix has been defying naysayers for several years now. It would be a shame if the seven-for-one split lures in a bunch of new retail investors just in time for a reckoning in the share price.

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