Apple And Google Stock Splits + DJIA = Potential Bonus Returns

Includes: AAPL, GOOG
by: John Tobey, CFA

Articles are promoting the idea that a split of $500 Apple (NASDAQ:AAPL) stock and $600 Google (NASDAQ:GOOG) stock could unleash buying by individual investors. The logic is that owning 10 shares of a $500 stock is unacceptable to many, but they would happily buy if they could acquire 100 shares at $50.

However, that rationale is usually incorrect. Studies show that, on average, a stock split does nothing to a stock's valuation or performance. And that makes common sense. Split a $100 share into two $50 shares, and there is no reason why the price should suddenly rise to $51. Even if smaller investors did decide to buy because the price was lower, one large investor could offset those small trades by selling on any unwarranted bump up in the price.

Note: There is a point where the logic holds up: When the price of even one share is too high for most investors. The best example is Berkshire Hathaway's Class A shares (NYSE:BRK.A) that sell near $120,000. Buffett's solution, rather than a split, was to issue Class B (NYSE:BRK.B) shares that currently represent 1/1500th of an "A" share and sell at about $80.

How the DJIA could make a split rewarding

The Dow Jones Industrial Average (DJIA), with only 30 stocks, maintains its close correlation to the overall U.S. stock market through careful stock selection. Leading companies are picked to provide sizeable representation and an appropriate allocation among the important U.S. economic sectors and industries. (The 30 stocks' market capitalization equals about 1/3 of the S&P 500's total.)

Dow Jones has made alterations over the years, expanding the scope of "industrial" to include financial, consumer and technology companies. (Excluded are the transportation and utility stocks that make up the other two Dow Jones long-term indexes.)

Dow Jones has kept the 30 stocks reasonably "fresh," making replacements as companies change (through merger, acquisition, and company successes and failures). And this raises the frequently asked question: When will the DJIA include Apple and Google? Both are in the Standard & Poor's 500 Stock Index (S&P 500), and their market capitalizations make them significant contributors to overall performance. These large, leading technology companies are notably absent from the current DJIA tech stocks: Cisco (NASDAQ:CSCO), Hewlett-Packard (NYSE:HPQ), IBM (NYSE:IBM), Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT).

The problem: Price weighting

As explained here, the problem is that Apple's and Google's share prices are too high. Because the DJIA uses price weighting, including the two stocks would unacceptably skew the index's behavior. Here's how the DJIA is currently allocated and how it would look if Apple and Google replaced, say, Cisco and Hewlett-Packard. The two would assume a ~40% weight and the technology sector would be about one-half the index. Clearly, neither weighting is appropriate.

(Click chart to expand)

DJIA tables showing price weightings

The solution: Apple and Google split their stocks

Therefore, the only way for Apple and Google will get into the DJIA is for management to split their stocks, thereby cutting the share price to an acceptable level. For example, splits of 10:1 would put their share prices into the average stock price area of $50-$60. A split of 5:1 (about $100-$120 per share) could maintain their perceived higher position, but still allow them to be added to the DJIA.

The bottom line

The DJIA's price-weighted construction means that Apple and Google, at their current prices, will not be added to the index. However, a stock split of 5:1 or greater could allow them to join the DJIA. As a result, buying of the newly added stocks by index funds could spur price rises simply from the stock splits, themselves.

While this is not reason enough to own either stock, it is a potential bonus return to holders.

Disclosure: I am long AAPL, INTC