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Splits 101

Stock Splits Defined

A stock split is an increase in a corporation's outstanding shares without a corresponding change in the shareholders' equity or the value of the corporation. When a company splits its stock, the share price declines by the ratio of the split. For example, a stock with a price of $100 splitting 2:1 would trade at $50 following the split (this is a simplified example that disregards typical price fluctuation). By the same ratio, a holder of the stock would possess double the shares worth half the price after the split date comes to pass. In the event of a 4:1 split, a holder of 50 shares would own 200 shares at a fourth of the price following the split, and so on.

Five Stages of a Stock Split

Since stocks perform uniquely during their split period, there are five classic stages that every split trader should be familiar with. These include Candidate, Announcement, Post-Announcement, Pre-Split and Post-Split. Behavior of stocks in during these phases varies according to current sentiment in the sector and broader market, previous price gains in the stock and length of time between the announcement and execution.

The first stage is the Candidate or Pre-announce stage. This is the time when investors begin to suspect the company will announce a split in the near future. Let's take a simple example. Company X has announced stock splits near $100 several times in the past. The announcements always came along with the earnings release for the second quarter. The stock price of X has been on the rise and has just exceeded $100. Second quarter earnings are due out in two weeks. In this scenario, investors could surmise that another split announcement is on the way.

Pre-Announcement Run on Sun Microsystems

Next comes the Announcement stage. When a company announces a split, the stock price can spike up, which often causes uneducated investors to enter positions with expectations for further gains. This is seldom a profitable move, as stocks usually fail to sustain this direction. We advise holding off on your play until this reaction has corrected itself.

$50 Split Announcement Spike on NetBank

The period following the split announcement, the Post-Announcement stage, often sees a depression. The excitement of the anticipated announcement is over and the actual date is known. The further away the date, the worse you can expect the depression to be. The closer the date, the stronger the pre-split run should be.

Post-Announcement Depression on General Electric

The Pre-Split phase occurs just prior to the actual split date. This is the easiest period to trade but also the most misunderstood as there are many factors that govern the way each stock trades before the split. This is normally the strongest phase of a stock split move.

Pre-Split Run on MacDonald's

Finally comes the Post-Split stage, the period that follows the split's execution. A depression in this phase one of the most dependable moves of a stock split. Traders have already had several trading opportunities in the weeks leading up to the stock split; momentum players exit their positions, driving the stock price down.

Post Split Depression on NetBank

All Five Stages of a Stock Split in Sun Mircosystems

Rationalizing a Stock Split

You may wonder why a Company would opt to implement a stock split. The most typical answer is to broaden a their ownership base and increase the number of shares available for trading. For many companies, a stock split is a rational means of increasing liquidity in the trading of their stock. For example, a stock trading at $200 is difficult for many individuals to own in round lots; to own 100 shares, one would have to invest $20,000 in the company. For many investors, this is impractical or impossible. Following a 2:1 split, however, an investor would need half the capital to buy a round lot; this is where the "broadened ownership base" comes into play.

A by-product of a stock split is often a reduction in the bid/ask spread; this phenomenon further facilitates trading.

There are also psychological factors involved. Many investors are unwilling to pay the "high price" for a stock and would prefer a stock that is more of a "bargain". Furthermore, since splits generally occur in the face of new highs, the split is surrounded by an array of positive associations and connotations, and can illustrate the strength of a company.

Keep in mind, however, that while a stock split can bring shares to a more attractive and affordable level for investors, the intrinsic value of the stock does not change at all. There are, in fact, multitudes of companies that announce stock splits just for the "hype factor", to promote the stock through the news generated by the split announcement. For this reason, it is important to thoroughly evaluate every stock purchase.

Profitability of Split Plays

Stock splits can provide lucrative opportunities because, as with earnings, they have the capability of generating enthusiasm and momentum. In fact, the two are probably the best momentum generators in the market. They provide a hook, or catalyst, for momentum traders. Without such events upcoming, momentum traders are not likely to be found in a stock. Without positive momentum, the best stock is going nowhere or even worse, down. Generally speaking, it's the added volume and excitement that makes a stock run; volume spikes in upward price movements are good signs that momentum traders are accumulating the stock.

Under these conditions there is outstanding opportunity for short-term price appreciation. When shares of a company have risen in value to the point that a split makes sense, the stock is under accumulation and when a stock has appreciated to the point that a split seems inevitable, the momentum tends to accelerate. This is especially true when a triggering event, such as a shareholders meeting, earnings release or Board of Directors meeting is scheduled, or when a date or timeframe in which the company has historically announced a split is approaching.

On the other hand, no amount of split hysteria will power a split run if the company just missed earnings or is the victim of some other negative news event. Stocks with very high floats are also less likely to have strong runs simply because of the number of shares outstanding. In reality, only a fraction of the stocks that split make good investments. The rest are simply trying to capitalize on the split craze to enhance their stock price.

Timing of Split Plays

The Pre-Split stage. Both events provide key opportunities for price appreciation

In the Candidate stage, a stock is widely believed to possess a myriad of factors that makes it a legitimate prospect for a split announcement. This prospective event often provides an outstanding opportunity for short-term price appreciation. It is a self-fulfilling prophecy, in essence, as the stock is probably running up to a higher level, anyway, which is causing investors to predict the split. In other words, when shares of a company have risen in value to the point that a split makes sense, the stock is under accumulation and enjoying momentum already. When more and more people begin to realize a stock has appreciated to the point that a split seems inevitable, the momentum tends to accelerate. This is especially true when a triggering event, such as a shareholders meeting, earnings release or Board of Directors meeting is scheduled, or when a date or timeframe in which the company has historically announced a split is approaching. Since many split announcements come with or on the heals of an earnings release, the anticipated declaration of a split can fortify the earnings run. Unlike earnings, though, it is not a rule of thumb to exit ahead of the expected announcement. If the events come in concurrence, though, the pre-announcement play should be dropped in advance, as sustaining a short-term position through earnings is not recommended.

The pre-split run is basically the same. Momentum is generated in the time leading up to the event, and through the payable date. The primary difference is that it is normally a solitary event; therefore the exit point is set and established. As with earnings, we recommend exiting split plays ahead of the split's payable date to avoid the short-term depression (mentioned above as the Post-Split Stage) caused by the momentum players' exodus. As a rule, the degree a stock has advanced into the split is directly related to the degree or severity of the post-news sell off. The extent and length of any post split or earnings depression varies.

An issue worth mentioning in this section is the record date. Many investors are confused by this, as it is mentioned in most split announcements with the statement "the split is payable to shareholders of record as of..." Let's start by saying that this date, regardless of the context in which it is used, is essentially worthless for our purposes. In times past, when stock certificates were physically held and all registration was done by hand, the record date had a significant role in the process of dividends (both stock and cash). That date was used to determine who was due the dividend based on shares owned prior to that time. In today's trading environment, however, actual shares rarely change hands; instead they are accounted for electronically through a central depository. In order for an individual to take part in receiving the additional shares from a stock split, he or she must own the stock as of the close of business on the payable date. Therefore, if you buy a stock subsequent to the record date, but hold it through the payable date, you are due to receive the additional shares. If, however, you own shares as of the record date, but sell before the payable date, you would not be entitled to the shares generated by the split.

Effects of a Stock Split

On the split's execution date, the price is adjusted by the designated ratio. To arrive at the post-split price you divide the pre-split price by the quotient of the ratio. In the case of a 2:1 split of a $100 stock, the quotient is 2 (2/1) and the pre-split price is $100. The post-split price would be $50 ($100/2). Accordingly adjusted by the split are the shares outstanding. Each shareholder will have more shares of the less expensive stock to equate the pre-split value of the aggregate shares. Each share will become the quotient of the split ratio, so in the above example shareholders would have 2 shares for each one previously held (hence the expression '2-for-1 split'). The total shares held by each shareholder are the number previously held multiplied by the quotient. The following common ratios effect the results described.

3:2 - 1 new share for every 2 held - Shares trade at 2/3 pre-split price and you have 50% more stock

3:1 - 2 new shares for each held - Shares trade at 1/3 pre-split and you have triple the shares

A couple of other things to keep in mind are a stock split's impact on past data and stops. Most charting packages adjust their graphs to reflect adjustments in stock splits'. When this occurs, the chart looks to continue seamlessly, as opposed to seeing a big drop on the execution date. In the case of charting packages that do adjust for splits, such as BigCharts.com or Quote.com's QCharts, what you see is the entire chart, prior to the ex-date, adjusted down by the ratio of the split (2:1, 3:2, 4:1, etc.). Most charts are created to do this for consistency in tracking moving averages and other indicators (e.g., the 5-dma would be severely distorted if the price weren't adjusted). As with price adjustments, most services adjust their data on past dividends and earnings per share (EPS) proportionately with the split. In the case of stop orders, most investment firms will simply cancel standing orders in the event of a stock split, instead of adjusting it by the split's ratio.

As mentioned earlier, the stock could be found more attractive to investors at its new price. Following the typical post-split depression, the shares should enjoy increased liquidity with more room to appreciate, not to mention greater recognition thanks to news surrounding the split.

 


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