How share splits and consolidation affect the value of a business

Stephen Bennie

Castle Point Funds

Share prices should be a reasonably accurate gauge of the intrinsic value of a company's valuation. It is then safe to assume that news which is fundamentally good for the value of a company, for example the successful launch of a new product, should see the share price rise commensurately. 

On the flipside, fundamentally bad news, such as an unsuccessful launch of a new product, should see the share price fall. That would be a reliable state of affairs in an efficient market. If a company were to announce that its CEO had started to experience premature balding and the share price was to drop as result, that would suggest the market was behaving irrationally. The reason for this is because while hair loss is not great personal news for the CEO it has absolutely nothing to do with the value of the business, unless of course the main product is one meant to prevent hair loss in adult males. But let’s assume it’s not, and that this news is completely irrelevant to the intrinsic value of the business.

Companies sometimes announce a share split. The share split ratio can vary, but a typical example would be the share split that Pushpay (ASX: PPH) announced in November last year. Management informed shareholders they would receive four ordinary Pushpay shares for each individual share they held as of 5pm on the Record Date of 26 November. 

Under these terms, an investor who held 10,000 Pushpay shares at close of trading had an investment valued at $68,400 due to the last trade occurring at $6.84. The next day they then held 40,000 shares, due to the four-for-one share split, but the share price drops to $1.71, which means the value of their investment is unchanged at $68,400. 

From that point, the value of their investment will fluctuate in line with subsequent share price moves. As I write this, the 40,000 shares would now be valued at $69,200 with the current share price at $1.73. This example, hopefully, shows that share splits change the number of shares that shareholders own but do not change the value of their investment and certainly do not change the intrinsic value of a business. Share splits are as relevant as the CEO going bald.

That begs the question, why on earth would a company go to the trouble of a share split when it means nothing for the value of the business. Companies sometimes refer to improving liquidity, as did Pushpay, but the reality is that this is not proven by academic studies, and indeed the value of shares traded in Pushpay in the 3 months before the split is greater than the value traded in the 3 months since the stock split. The real reason that companies do share splits is that they have found that to (some) investors a high share price is synonymous with an expensive and overvalued company. In the case of Pushpay by carrying out a 4 for 1 share price, they reset the share price from $6.84 to $1.71. And it had been a great buy at $1.71 a year ago, so it must be cheap now back at those levels. As explained above that is highly flawed reasoning but a raft of academic studies have shown that investors are prone to making that cognitive error.

At the other end of the spectrum are share price consolidations which companies will sometimes do to take a share price from a few cents to a dollar or more. This manoeuvre if generally executed to move a share out of the penny dreadful territory to a more normal level. Again, this has absolutely no bearing on the value of the business but can have a bearing on investors perception of the value. A recent example of this was the share consolidation that Capral did in November last year. Their consolidation was 1 share for every 30 held on 4th November. This ratio was probably about right when the Capral board first started considering a share consolidation, its share price was around 10c and this ratio would move the price to around $2 a share, a far healthier looking level. However, it just so happened that the company was about to go on a mini upgrade cycle with earnings upgrades in October and December. The result was that in January the share price had risen to nearly $7; time for a share split!

Castle Point has taken all reasonable care in the preparation of these articles, however accepts no responsibility for any errors or omissions contained within. Past performance is not necessarily an indication of future performance. Opinions expressed in these articles are our view as at the date of issue and may change

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Stephen Bennie
Castle Point Funds

Stephen has over 25 yrs investment experience & co-founded Castle Point, a NZ boutique fund manager, in 2013. Prior to that he worked at funds management companies in Auckland, London & Edinburgh. Castle Point WINNER FundSource Boutique Manager 2019

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