Thursday, April 26, 2012

Coca Cola's stock split

Coke is in the news because it has just announced a 2:1 stock split.  Predictably the price went up on the announcement, although the reasons why the price should go up are shaky at best.

Lets take a look at some of the arguments:
  • Coke's CEO has argued that this will increase the liquidity of the stock.  But for a stock like KO which already has a bid-asked spread of only a penny, it is unclear how the liquidity could be increased much further.  
  • An another explanation is that this somehow makes the stock more affordable for every day investors.  This is sometimes called "the optimal trading range hypothesis".   But this makes little sense really as investors can vary the number of shares that they buy.  Also, by this reckoning a $40 stock today is massively more affordable than a $40 stock 30 years ago.  Apple and Google also don't appear too bothered about this - both have stocks trading for the hundreds of dollars.
  • KO has stated that the split decision is based on the board's long term positive expectations for the stock.   But for this signal (of a positive future) to be credible, it has to be costly and hard to fake.  This is not really the case for a stock split - they are pretty cheap to do and anyone can do it.   I will note however, that if you knew that your future outlook was bad, then a stock split might not be a good idea if it would result in the price being so low that the stock could be de-listed. 

There is also quite a bit of confusion about price reactions around stock splits.  The largest price reaction typically occurs on the announcement date and is on average around 2%.  On the actual pay date - the date of the split - the price reaction is much smaller, only around 0.5%.   Even 0.5% is surprising as there should be no price reaction around a previously know event (counter to what this article suggests).

In conclusion, stock splits don't make a lot of economic sense from the point of view of shareholders.  They should be non-events.  But they might make sense for executives in particular if these executives have stock and option based compensation that would increase in value from the price pop around a stock split.  In fact, this is the very result that I find in a working paper with Bill Elliott and Erik Devos.  We're currently revising the paper to expand the data set and explore some other results before we send it back to a journal.  I'll post more on the topic when we get the results written up.