Why stock splits like Amazon's are an antiquated move
Amazon is the latest of the tech behemoths to split its stock, giving its share price a knee-jerk bump on Monday.
Why it matters: Well, the thing is ... it doesn't. Not really. Amazon's split means one of its shares now becomes 20, and the price of one share is lower. It does nothing to improve the underlying fundamentals or profitability of the online retailing and web services giant.
How it works: Think of a public company as a pizza. Its shares are slices. A stock split is merely a way of cutting the same exact pizza into thinner slices.
- That's it. Nothing else changes.
- The size of the pie stays the same. The crust is no more crisp and delicious, the pepperoni no more salty and piquant, the cheese, no cheesier.
- In a two-for-one split, each piece you own is simply chopped into two pieces. Amazon split its shares 20-to-1.
- If you owned one share on Friday when Amazon was trading at roughly $2,500, you now own 20 trading at around $125.
The backstory: Once upon a time, stock splits were a way for companies with soaring share prices to make it easier for investors to buy their stocks — and in turn, more buyers help prop up the price.
- This was thought to be particularly important for individual traders, who sometimes didn't have the cash on hand to buy the 100-share lots that were the standard unit of stock trading. Trading smaller lots often meant paying much higher commission payments to brokerage firms.
- During the tech stock boom of the late 1990s, stock splits rose in popularity and were often associated with huge surges in share prices — which, in hindsight, were simply a sign of the manic quality of the markets in that era.
Yes, but: All that is ancient history. Today, stock trading is largely commission-free. And if you can't afford to buy a whole share of, say, Amazon, which last week was trading at around $2,500, you can buy so-called "fractional" shares, which allow you to buy, you guessed it, the fraction of the share that you can afford.
And, yet: Amazon's stock price rose roughly 2% Monday after its split, beating out the Nasdaq which was up just 0.4%. What gives?
Our thought bubble: Well, it depends on what you think the stock market is. If you think it's supposed to be a massive hive-mind calculator constantly estimating and re-estimating the outlook for a company's corporate profits, revenues and future dividends, it makes no sense for a split to generate a boost in price.
- On the other hand, if you think the stock market is also a massive casino, where humans with all their foibles are constantly fumbling around placing bets in an effort to predict what stocks other investors will bet on, splits make a bit more sense.
- For instance, some academics have noticed that people tend to see lower priced stocks as having more potential to rise than higher price stocks.
The bottom line: To be clear, this isn't true. It's an irrational belief. So, it's sort of silly for a stock to rise because a split lowers its price.