What are stock splits and are they good for shareholders?
Markets tend to react positively when a firm announces a stock split, which can benefit firms in a number of ways, writes UNSW Business School's Mark Humphery-Jenner
There have been several high-profile stock split announcements in 2022. Tesla has announced its intention to split its shares, operationalised via a stock dividend. Similarly, Alphabet – Google’s parent – has indicated it would see a 20:1 stock split. The market reacted positively to both announcements. But, are stock splits good for shareholders? And, if so, why?
What exactly is a stock split?
Stock splits and stock dividends achieve similar results. A stock split simply ‘splits’ the stock by converting each individual stock into N stocks. For example, a 2:1 stock doubles the number of shares. Each shareholder would then own two shares instead of one share. A stock dividend involves issuing more shares to the shareholders. Thus, each shareholder obtains more shares in proportion to their prior shareholding.
Each shareholder’s percentage ownership remains unchanged. Stock splits do not themselves alter the firm’s earnings or cash flows. They do not involve the firm obtaining additional cash for the shares. Thus, they are not like a seasoned equity offering.
How does the market react to splits?
The empirical evidence suggests that the market reacts positively to stock splits, on average. A complication is that stock split announcements often coincide with other corporate disclosures, ranging from earnings announcements to explicitly stated managerial forecasts. Nevertheless, the positive market reaction is consistent across the literature. Further, some firms might signal an intention to split their stock before officially having the approval to do so.
The preponderance of empirical evidence suggests positive returns around splits. The magnitude varies across studies. For example, some studies split announcements result in returns ranging from 1.6 per cent through to 3.38 per cent. The magnitude varies over time. Further, this is not isolated to specific markets. For example, there is evidence that stock dividends – which achieve much the same outcome as stock splits – have a positive market reaction in China.
This holds in myriad locations and financial instruments. For example, American Depository Receipts (ADRs) also increase in price around stock splits. Splits can also manifest in informed trading in other financial instruments, as sophisticated investors commence trading in the options market.
The evidence thus suggests that the market likes stock splits. Clearly, each split and announcement must be evaluated on its own merits. And, it is important to disentangle contaminating events. But, the market appears to believe splits are good news. But why?
Why might the market react positively to stock splits?
The issue is then why the market might respond positively to firms announcing stock splits? The stock splits do not change shareholders’ percentage ownership. Further, the split does not change earnings. This begs the question of why the market might react positively to stock split announcements. Indeed, there are several reasons for the market to react positively even if the firm does not release other positive information at the same time as a split announcement.
Dividend and earnings signaling: A stock split might signal that the firm intends to increase total dividends and/or that earnings will increase. However, the evidence on this is not conclusive. A stock split itself does not contain any guarantee about dividends. Indeed, the market reacted positively to Tesla signaling a split even though it does not offer dividends. However, depending on the managers’ statements, the market might infer that total dividends will increase and that the firm will not reduce dividends pro rata with the increase in the number of shares.
Stock price predictions and private information: The decision to split the stock might be a signal of managers’ expectations about future performance. Intuitively, the logic is that managers choose to split the stock if they believe the price will continue to increase. If managers felt that the stock price would remain stagnant or decrease, then they would not split the stock as presumably they were heretofore accepting of that stock price. Thus, a decision to split signals positive private information about future performance.
The evidence tends to suggest that managers do indeed base split decisions based on beliefs about future performance, including earnings. For example, there appears to be a relationship between so-called ‘informed trading’ in the options market and stock splits; however, this could relate to stock price volatility in addition to earnings expectations.
Liquidity: Stock splits can increase stock liquidity. Stock liquidity arises when there is an active market for a stock. This prevents any individual trade from having a long-lasting market impact, narrows bid-ask spreads, and causes prices to be more accurate, over the long run. A stock split could arguably increase liquidity by making the stock more accessible to retail investors. There might be a marginal change to institutional investors’ decisions. However, given the large amount of money that institutional investors manage, any such change would appear relatively small. The increased retail investor activity might also explain why volatility appears to increase after a split.
Liquidity has several fundamental benefits for companies. These benefits are not contingent on ‘demand’ for the stock pushing prices higher. Indeed, one of the key implications of liquidity is that such price impact should be short-lived and stock prices should trend towards their fundamentals. Rather, liquidity benefits firms over the long run by enabling them to price stock more accurately when offering stock. Further, it can improve debt terms given that some default risk models use inputs from equity markets. Additionally, it makes managerial incentive programs more effective by making it easier to observe stock price movements.
Liquidity benefits can be a significant reason for the market’s positive reaction to split announcements. Evidence of this comes from American Depository Receipts (ADRs), which are a form of cross-listing. Here, a firm lists a ‘stock’ in the United States but also keeps a stock in its home market. Thus, it has stocks trading in different markets. If the firm splits its ADR but not its home stock, then the only change in the ADR is to its liquidity: there would be no other signaling about the firm’s value. Empirical evidence shows that even here, an ADR’s price increases following a split. This suggests a significant liquidity effect in stock splits.
Index inclusion: A firm might split its stock in order to be included in a stock market index. Index inclusion is non-negative for firms. Being in an index has no downsides. It might also increase investor interest from institutional investors that track an index. This might increase liquidity. Further, media reports on index components can constitute a small amount of ‘free’ marketing, especially to retail investors. Thus, being in an index is generally positive for firms.
Most stock market indexes include the largest N firms by market capitalisation. For example, the ASX/S&P 200 includes the largest 200 firms on the ASX. Market capitalisation is the stock price multiplied by the number of shares outstanding. Thus, for most indexes, the stock price per se is relatively unimportant. However, this is not the case for all major indexes.
Some significant indexes are ‘price-weighted. This includes the Dow Jones Industrial Average (the “Dow”). The Dow includes 30 stocks in the United States. The criteria for inclusion are slightly opaque. However, because the Dow is price-weighted, it avoids including stocks whose price would cause them to dominate and skew the index. Thus, firms might split their stock in an attempt to qualify for an index.
Overall, stock splits are generally non-negative for shareholders. Shareholders’ percentage holding in the company remains unchanged. And, the stock split does not reduce the firm’s cash flows or earnings. The split could improve liquidity, index inclusion, and might signal positive information about future earnings and dividends. This can help to explain why the market tends to react positively when a firm announces a stock split, even after controlling for managers announcing other information at the same time.
Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals and his research interests include corporate finance, venture capital and law. For more information please contact A/Prof. Humphery-Jenner directly.