The recent earnings announcement by Apple (NASDAQ:AAPL) excited the market as the company beat the estimates on both top line as well as bottom line. The stock has made a considerable jump after the earnings announcement and the future prospects of the company have brought excitement back to this stock. My fellow SA authors have done a fine job of analyzing the earnings as well as the different business segments and the growth shown by these business segments. Furthermore, some authors have also talked about the proposed changes in the capital plan of the company. Along with changes in the capital plan, the company also announced a 7-for-1 stock split, which has not received necessary coverage on this platform - some authors have mentioned it briefly and how it might result in Apple joining the Dow. However, I believe this topic needs a bit deeper analysis.
Neo-classical theory says that the stock split is just a numeric adjustment and it does not have any impact on the valuation of the stock - in theory, that is correct. A stock split results in more shares. However, the total value to shareholders remains the same and the market cap of the company is not affected due to the stock split alone. In Apple's case, the stock split will impact the owners of the shares at the closing price of June 02, 2014 - all shareholders of Apple on that date will receive six additional shares of the company, and the trading on the post-split levels will start from 09 June 2014. Keeping in mind the current stock price and the expected rise over the next few days, the stock price after the split will be between $80-85 per share, and the per share dividend will be $0.47 ($3.29/7). So, the total value of the stock will be unaffected in purely mathematical terms. However, when we talk about the stock markets, we also need to take into account two extremely important factors: Sentiment and psychological impact of an announcement. These two factors sometimes contribute more toward the valuation of a security than the mathematics involved.
Stock splits are done for a number of reasons - the theory of asymmetric information plays a vital role here as management has access to critical information and uses the measure to sometimes indicate to the market the future direction of the company. The most common signal sent by a stock split is that the management is confident in the future prospects of the business and growth will continue. It is highly unlikely we would see a struggling company perform a stock split as it will further dilute the EPS - in fact, struggling companies tend to do the opposite (reverse stock split) in order to enhance the EPS. Apple's stock split is unusually large and it clearly shows that management is not concerned about the future profitability of the business. However, Apple's other steps (increased share repurchase and dividends along with rapid growth in business segments) were enough to convey this message to the markets, and it is clear that the stock split was intended for another purpose.
In my opinion, the sole purpose of this stock split is to enhance the clientele for the stock. Stocks with sky high prices tend to discourage smaller investors - at the current price level, a retail investor might have trouble buying four Apple shares. However, after the stock split, the same investor might be able to buy 15 shares of the company. Again, the major factor here is the psychological. In terms of profit and valuation, there will not be any difference, but the psychological impact will be far greater. If we ask a retail investor which stock will he/she buy - one share for $70 or seven shares for $10 each - the answer will be seven shares for $10 each most of the time. Retail investors usually derive more satisfaction from holding a larger number of shares for a growing company. At the moment, 62% of Apple's float is held by institutional investors - institutions usually do not care about the level of the stock price - the investment allocation for institutions is not affected by stock splits and I expect the institutional ownership to be unchanged post-split.
However, the remaining float of 38% will see a higher activity, meaning volatility will increase. The lower price will attract more investors and demand for the stock will increase. Now, current Apple shareholders might not want to decrease their positions after such a successful quarter and the expected launch of new products - as a result, the demand will far outweigh the supply in the market and we might see unusual activity in the stock price over the next two to three months. The stock split has come at an interesting time - the earnings announcement has reinvigorated the belief that Apple can continue its growth and it is unlikely that the growth will slow in the short term. Ideally, the current shareholders of Apple would try to accumulate more shares in order to enjoy the growth opportunity offered by the company. The scenario becomes extremely interesting here - the 38% float for retail investors will be in high demand as new investors as well as current shareholders will be trying to accumulate the shares.
Furthermore, Apple's stock sees heavy activity in the options market - in the past, investors have been using options to enjoy the growth opportunity offered by this stock. However, as options are risky and a tricky subject, majority of the investors were not able to enjoy the profits. However, the stock split will allow low-risk tolerance investors to buy shares without using options. On the other hand, the expert options traders will also benefit from the stock split as the option premium in terms of dollar will come down and the traders will be able to secure more options. However, retail investors with a low understanding of options should stay away and leave the options to expert traders only.
Finally, let's talk about the liquidity. The common belief is that the stock split increases the liquidity for a stock. However, there is no empirical proof of an increase in the liquidity. In fact, as I mentioned above, the stock split might result in lower liquidity for Apple as current shareholders as well as new investors will try to accumulate in the short-medium term at least.
I do not agree with the notion that the stock split will not impact the stock price of Apple - in the short-medium term, I believe the stock price will be positively impacted by the split as the increased demand will result in increased volatility. Lower stock prices attract retail investors, which results in higher volatility. We have a company that is growing at an exceptional rate and has some of the most impressive fundamentals. Apple stock with a forward P/E of 12 and 3-year average net income growth of over 38% will be an extremely attractive investment opportunity for retail investors and it will certainly attract a larger number of investors.
Additional Disclosure: This article is for educational purposes only and it should not be taken as an investment recommendation. Investors are urged to do their own due diligence before making any investment decision.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.