March 2021 - How share splits and consolidation affect the value of a business

Share prices should be a reasonably accurate gauge of the intrinsic value of a company of which it is a share. 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. While 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 whatsoever to do with the value of the business, unless of course the main product of that business was one that stopped hair loss in adult males but let’s assume it’s not and this news is completely irrelevant as regards to the intrinsic value of the business.

Sometimes some companies announce that they are going to have a share split. The share split ratio can vary but a typical example would be the share split that Pushpay announced in November last year. Pushpay informed shareholders that they would receive 4 Pushpay ordinary shares for every 1 Pushpay share held at 5pm on the Record Date, which was 26th November. That meant that an investor that held 10,000 Pushpay share at close of trading had an investment valued at $68,400 due to the last trade occurring at $6.84. The next day they were now holders of 40,000 shares, due to the 4 for 1 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!