Why do companies split their shares, and what do investors gain, if anything?
With the recent rise in stock prices, more companies are deciding to split their shares. Two high-profile examples are Toronto-Dominion Bank and National Bank of Canada, both of which announced two-for-one stock splits this week, effective Jan. 31 and Feb. 13, respectively.
In both cases, the companies are accomplishing the split by issuing a stock dividend of one common share for each common share outstanding, with no tax consequences for investors.
It's important for investors to realize that stock splits, in and of themselves, don't add any economic value. After a two-for-one split, you'll own twice as many shares, but each share will be worth half of what it was before (all else being equal).
So why bother? Well, companies want to encourage retail investors to buy their shares, and they figure that more people will be interested if the price is low. This reasoning may hark back to the days when investors usually had to buy shares in multiples of 100 – called board lots. If the shares got too pricey, some investors might not have been able to afford them.
With modern trading systems, investors can usually buy a fraction of a board lot without any trouble. But some companies still think it's important to keep their share prices from surging to levels that might turn off some retail investors.
As National Bank explained in a Q&A on its website: "The Bank is undertaking the share dividend to ensure that its common shares remain accessible to individual shareholders and to improve market liquidity for the common shares."
To be sure, not every company is sold on the benefits of stock splits. Google and MasterCard, for example, have never split their shares, and it's been years since Apple or Amazon.com did. On the S&P 500, about 75 companies trade for more than $100, and two index members – Google and Priceline.com – are priced at more than $1,000. One theory is that there is a certain cachet that comes with having a triple- or quadruple-digit stock price.
Still, even though stock splits don't add value, research indicates that they may give investors important signals about the strength of a company.
In a 1996 study, David Ikenberry of Rice University examined 1,275 U.S. companies that split their shares between 1975 and 1990, and compared them to companies that did not split during that period. Result: Shares of 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."
This is not to suggest that stock splits cause share prices to rise or earnings to grow. Rather, companies that announce splits tend to be doing well already – that's why their share prices have risen – and the decision to split reflects management's confidence that the good times will continue. What's more, splits are often accompanied by other positive news – strong quarterly earnings and dividend hikes, for example – that give the stock price a lift.
So, while stock splits by themselves won't make you money, they can be a sign of a solid long-term investment.
Editor's note: A previous version of this article incorrectly included Amazon.com as a stock priced at more than $1,000. It should have said Priceline.com.