Corporate stock splits are often noted in financial news, although contrarian views exist as to whether a stock split is beneficial. In general, a stock split is a corporate action that increases the number of the corporation’s outstanding shares by dividing each share, which in turn diminishes its price.
Many “average” investors are ecstatic upon receiving news of a stock split, as a split appears to be greatly advantageous since the number of shares in their portfolio increases. For example, if Finnegan owns 100 shares in ABC Corp and each share is worth $80, after a two-for-one stock split, Finnegan will own 200 shares in ABC Corp, each worth $40. But, as with many financial matters, there are far more sophisticated factors that must be considered in determining whether a corporate stock split is beneficial. The following is a light-hearted discussion regarding the advantages and disadvantages of a stock split and whether a stock split or a dividend will provide greater benefit to investors.
Eric Lee (EL): Lately, we have been having some heated discussions about the utility of stock splits. I wish to finally disabuse you of your unenlightened approach to stock splits and I wish to do it in public.
Andrew Corbett (AC): Alright, while I do respect you as a fine colleague, I am curious as to exactly how you intend to “disabuse” me?
EL: Stock splits are nonsense—they are merely forms of paper shuffling that provide no value to the shareholder. The only benefit they provide are volatility and we do not need to introduce any more chaos into the system.
AC: Your previous comment does not take all market factors into full consideration. There are many studies, such as one performed by Forbes dated August 25, 2005, demonstrating that companies splitting stock often outperform those that do not split their stock.
EL: Why do you think that is the case?
AC: It is quite simple my unenlightened colleague. Stock splits provide affordability. If ABC Corp is worth $40 now versus $80, that means more people will purchase the stock. A lower per-share price increases demand, which will increase the price of the stock.
EL: I find it curious that you bring up an intellectual argument. If that is the case, why aren’t all stocks continuously splitting to one dollar; and why stop at that, why not 25 cents? Surely, everyone in America can partake in the dream of owning a slice in a company when Berkshire Hathaway Inc. is priced at five nickels.
AC: Well, there needs to be a floor, otherwise, if everyone purchases stock, it becomes an accounting nightmare due to all the transactions to record. Also, you fail to recognize that there is some administrative cost to a stock split making an infinite number of splits unfeasible. Further, there is a point at which the demand will flood the market. You did take Economics 101, didn’t you?
EL: Andrew, your argument is unavailing. Remember, it is our job to inform people of our research, not to prey on their ignorance. Regarding the issue of reducing the stock to absurdly low levels, with computer technology that can launch spaceships to far-flung reaches of the cosmos, I am sure we can do simple arithmetic on a spreadsheet.
AC: Eric, you are quite capable of complaining, but do you have a better suggestion in providing value to a shareholder?
EL: Why, yes I do—cash.
AC: In the form of dividends. Are you insane? Double taxation is anathema.
EL: Andrew, I will touch on the issue of double taxation later. However, I believe that even though it is an inefficient distribution of capital, a dividend is superior to a stock split because I would rather have cash.
AC: You get taxed on the dividend, not on the stock split. Further, you are taking money out of the company in the form of a dividend. However, with a stock split, you instead increase the outstanding shares without the company having to pay out the profits to the individual investors. You are familiar with how a dividend and a stock split work, are you not?
EL: But what do you get? At least I get two dollars in the form of a dividend. I don’t get anything from a stock. Sure, I am taxed at ordinary income for the dividend, but at least I get something. Andrew, I am going to indulge you, something that I am sure very few people do. Even Benjamin Graham stated in “Security Analysis” that, “The responsibility of managements to act in the interest of their shareholders includes the obligation to prevent—in so far as they are able—the establishments of either absurdly high or unduly low prices for their securities.”
AC: Eric, that is Ivy League, disenfranchised from mainstream America, talk. You can quote all the intellectuals you like—clearly you would not disagree with the statement that a stock split does not violate the U.S. Securities and Exchange Commission (SEC), would you? You would rather have a company provide cash dividends to people when they are already taxed to the grave. You are violating the markets by stripping away a mechanism of buying back stock to get around the onerous tax code. I would also like to take this time to point out a very simple fact: Some companies do not issue dividends as a policy, such as Apple Inc., for example. Are you going so far as to say that at least Apple Inc. is not exemplary of free market enterprise?
EL: You easily run around the double taxation issue of dividends by opening up a Dividend Reinvestment Program (DRIP). Any company you invest in can convert the dividend policy into a DRIP, as all DRIPs are practically free.
DRIPs allow investors to purchase shares in two ways, either through reinvesting dividends or with optional cash payments that can be sent to the companies you want to invest in.
AC: Though, in many situations, you are still taxed on the income.
EL: There is the legal background you are known for, Andrew. Yes, many DRIPs do require taxation on the dividend payment; however, there are many that do not. Such non-taxable dividend reinvestment plans include some Dow components, which offer both traditional and ROTH IRA dividend reinvestment plans. It is all quite simple.
AC: But Eric, there are many people who do not own common stock. Their investments are in mutual funds. Moreover, most investors would not know (until reading this publication) that you could open a DRIP. Once again, a lack of perspective from your ivory tower. I believe your elitist views are clouding your common sense. Do you truly think those who do not understand the workings of the market or basic economic theory will take the time to research a traditional or ROTH IRA DRIP program?
EL: Andrew, you argued one of the virtues of a stock split is that the company will be providing value to the shareholder without impacting its balance sheet because it doesn’t cost the company anything. Well, neither does a DRIP. The company keeps the money for the dividend and the impact on its balance sheet is a nullity.
AC: Eric, my young friend, the difference should be obvious. With a DRIP, you are assuming the company could pay out a dividend. It is up to the individual shareholder to essentially “opt out” by participating in the DRIP. With a stock split, you do not encounter this issue.
EL: Andrew, a central tenant of “free markets” is to provide as much choice as possible. I am merely stating that you might be able to feed a multitude with 12 baskets of fish and bread, but you get nothing for a two-to-one stock split.AC: Eric, your argument is simply incorrect. As we previously discussed, the value of the stock will increase due to more investors entering the market to purchase the stock—this is basic supply and demand. As the supply increases, the demand will increase. When done prudently and in the best interest of the investors, this will result in an increase in stock price. This is a case in which one plus one will equal three.
Eric Lee is a senior tax associate. He earned his Juris Doctorate from DePaul University College of Law. He is also a graduate of Vanderbilt University with a Bachelor of Arts in Economics and Corporate Finance.
Andrew Corbett works in Business Development at ABS-GPS. He is responsible for advising senior business analysts on identifying potential areas for tax planning, asset exposure and estate planning for clients. Andrew obtained his undergraduate degree in Political Science with a minor in Business Administration from Northern Illinois University and his Juris Doctor from Chicago-Kent College of Law.