Recently, the stock price for Apple, Inc. (AAPL) significantly increased on the speculation that the company would split its stock, thus making AAPL a candidate to be included in the Dow Jones Industrial Average (DJIA). For traders, as well as investors, it is important to understand the implications of a split in the price of AAPL stock and its effects on the DJIA.
Before we focus on the effects of AAPL's inclusion in the DJIA, we need to understand the composition of this Index, how it is weighted, and which stock in this Index is likely to be replaced by AAPL. In addition, we need to review the procedure of how a stock split takes place.
The DJIA is composed of thirty (30) actively traded blue chip stocks. These stocks, and their weight in the index, are shown in the table below:
% Weighted in the Index
Johnson & Johnson
Procter & Gamble
Bank of America
Indices are weighted either based on price or market capitalization. The DJIA is weighted according to price whereas the S&P 500 Index is weighted based on market capitalization.
What is a Price-Weighted Index?
A stock index, in which each stock influences the price of the index in proportion to its price per share, is a price-weighted index. The value of the index is calculated by adding together the price of each of the stocks in the index and dividing that total by the number of stocks in the index. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.
As you can see in the table above, as of this writing (July 31st, 2012), IBM has the most weight (11.43%) in the DJIA since it is the highest price stock in the Index. Second in weight is Chevron and at the bottom of the list is Bank of America with a weight of 0.42 percent. Therefore, the price movement of IBM stock has much more effect on the DJIA than the price movement of BAC.
IBM currently has a price of $198.52 and AAPL currently has a price is $615.70. Therefore, if AAPL were to be added to the DJIA, then AAPL's weight would be over a quarter of the entire index and would defeat the purpose of the Index! The inclusion of AAPL in the DJIA would mean that the price of the Index would move up or down based on the price of AAPL stock.
Which stock may AAPL replace in the DJIA?
Since there can only be thirty stocks in the DJIA, then one of the currently listed stocks must be deleted to make room for AAPL. Which stock could that be? There are two likely candidates: HPQ and KFT.
When you look at the table above, you will see that there are five technology stocks included in the DJIA. These are IBM, HPQ, MSFT, INTC, and CSCO. Out of these five companies, HPQ is the most direct competitor of AAPL. In addition, AAPL has a market capitalization that is almost 16 times that of HPQ. For the year 2012, the price per share of AAPL has raised nearly $203, whereas the price of HP stock is down $7.25 per share. If AAPL were included in the DJIA (without any stock splits), then this Index would be higher by almost 1600 points and would have traded above 14,600; which is above the all-time DJIA record high of 14,198, set on October 9, 2007. If AAPL were to be included and HPQ not deleted, then the DJIA would be heavily weighted by technology stocks. And, since all stocks in one sector tend to move in tandem, this sector would have a disproportionate effect on the DJIA.
The second candidate for replacement is KFT, which is spinning off later this year into two separate companies. One will be named Mondelez International and will market such famous brands as Cadbury chocolate and Oreo cookies. The other company will retain the name Kraft Foods and will market products such as macaroni and cheese, cream cheese, and coffee. Because the spinoff will create two smaller companies and KFT's rank is already a meager number 20 in the DJIA rankings, after the spinoff, KFT may fall to a very low level in the rankings. Therefore, KFT could be a candidate for replacement if AAPL is included in the DJIA.
Another possibility is that both HPQ and KFT are removed from the DJIA and, besides AAPL another company is added to the DJIA. In this scenario, AAPL would replace HPQ and KFT would be replaced by another company.
However, inclusion of AAPL in the DJIA, at its current price of over $600, has a very slim chance happening since the DJIA is a price-weighted index. Therefore, AAPL has a higher chance of being included in the S&P index which is based on market capitalization.
One way for AAPL to be included in the DJIA is for AAPL to complete a split of its stock price, such as 2-1, 3-1 or even 4-1. Three times in the past, AAPL has split its stock price; each time in a 2-1 exchange. These splits took place in June 1987, June 2000, and in February 2005. However, if AAPL does split 2-1 this time, even then, AAPL will be the most heavily weighted stock in the DJIA. It will have a weight of 15.4% and outweigh IBM which stands at 11.43%. If AAPL completes a 3-1 split, then AAPL's weight would be 10.8%; 2nd in rank. Then, if AAPL's stock price increases, it may become the number 1 ranked stock in the DJIA.
Since AAPL is the largest company in the world by market capitalization, out distancing ExxonMobil by $170 billion, and its products are loved all over the world, it makes sense for AAPL to just split in a 2-1 ratio and, therefore, become a likely candidate to be added to the DJIA. Even if AAPL completes a 3-1 stock split, it will be second in weight in the DJIA and could overtake IBM in the near future. Therefore, logic dictates that AAPL will not seek a stock split for more than a 3-1 ratio. Another factor which favors the idea that the DJIA will include AAPL is the fact that AAPL now pays a dividend, just like the other components of the DJIA.
What is a stock split and what is the likely performance of a stock like AAPL after a split
All publicly-traded companies have a set number of shares that are outstanding in the stock market. A stock split is a decision by the company's board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders. For example, in a 2-for-1 stock split, every shareholder with one share is given an additional share. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after completing a 2-1 stock split. As of today, AAPL has 937.41 million outstanding shares. If AAPL decides to complete a 2-1 split, then the outstanding shares after the split would be 937.41*2 or 1,874.82 million shares.
A stock's price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased. In the example of a 2-for-1 split, the share price will be halved. Thus, although the number of outstanding shares and the stock price change, the market capitalization remains constant. In the case of AAPL, if AAPL is trading at $600 and you are holding 100 shares of AAPL, after the split you will have 200 shares of AAPL and ideally AAPL should be trading at $300. So, on the date of split you will not see the effect of the split in your portfolio, other than the increase in the number of shares.
However, the research indicates a clear relationship between stock splits and stock price performance. Most traders view stock splits as high potential trading opportunities. They consider splits to be positive and it brings goodwill for the company and the investors. Corporate executives use stock splits as marketing and investor relation tools. They know that stock splits make shareholders feel better by giving them a sense of greater wealth.
Research indicates that stocks which are split perform 8% better during the next three years than the companies which do not split. Some companies even reach their pre-split price in a matter of eighteen (18) months, thus giving the investors an abnormal return on their investments.
Another vital factor is that, since the price of the stock is reduced after the split, it attracts many smaller traders and investors. In addition, many companies report higher earnings and an increase in dividends payout, which attracts even more investors.
In summary, when you consider a stock split, dividend payments, and the possible inclusion of AAPL, either in the DJIA or the S&P, it is no wonder that the price of AAPL stock has been running up after it dropped on its earnings announcement. If AAPL is included in the DJIA, many index funds will be forced to buy AAPL shares. This will drive the price of AAPL stock even higher. And, on top of all this, after the split it would be almost expected that the price of AAPL stock will increase towards its pre-split price. In large part, this is due to AAPL's status as the most beloved company in the entire world and that investors believe it will continue to deliver profitability in the future, despite the untimely death of Steve Jobs.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.