The conventional thing to say is that a stock split doesn’t change anything important about a company or its stock. You have a share of stock that trades at $1,000, you split it 10-for-1, now you have 10 shares that trade at $100 each, nothing has changed, who cares. In the olden days this mattered more, because it was cheapest and easiest to buy shares in “round lots” of 100 shares; a $100,000 round lot would price a lot of investors out of the stock, while a $10,000 round lot would increase demand for the stock. But in modern markets it is basically as easy to buy one share as 100, and at most retail brokerages these days it’s just as easy to buy 0.05 shares or whatever other fraction you want. So nobody is really priced out of a stock by a high-dollar price tag, so splitting the stock shouldn’t attract new investors, so it shouldn’t matter.
I want to defend stock splits. Splitting your stock can make the stock go up, and there is a logical explanation for it. Here’s the news hook, from Bloomberg News today:
Recent proposals from Alphabet Inc., Amazon.com Inc. and Tesla Inc. tell us one thing: Stock splits can spark big rallies as retail traders pile in.
Tesla surged 8% Monday, adding about $84 billion to the company’s market value, after saying it’s planning a second stock split in less than two years. Amazon jumped more than 5% the day after announcing a 20-for-1 split this month and the stock has been on a tear ever since.
In theory, this shouldn’t happen. A split doesn’t affect a company’s business fundamentals, and investors averse to a stock’s high price tag can simply buy fractional shares instead. Yet splits are causing day traders to pile in, fueling rallies in these companies’ shares.
“We simply cannot fundamentally explain how a stock split can add nearly 1.5 times the market cap of General Motors or one full Volkswagen’s worth of market cap to Tesla almost instantly,” Morgan Stanley analyst Adam Jonas wrote in a note to clients.
But let’s try. (Not “fundamentally” but whatever.)
While the stock market doesn’t really trade in round lots anymore, the options market does: If you want to buy listed call options, you have to buy them in contracts of 100 shares. (There are weird market-structure reasons for this. Most retail stock trades are internalized, with the retail broker routing your order to some market maker who will fill it from its own inventory, and if it wants to sell you fractional shares that’s fine. Listed options have to trade on the exchange, the exchange has 100-share contracts, and you can’t get around that by buying half a contract from a market maker.) So if you want to buy a Tesla call option struck at $1,100 expiring on April 14, you’ll pay about $5,500 for one contract ($55 per share for 100 shares). If Tesla did a 10-for-1 stock split, you could buy options for as little as $550.
Again, I used to think that this didn’t matter, because options trading is either (1) for professionals, who can afford $5,500 a throw, or (2) for retail weirdos, who can’t be the driving force of corporate finance. But I do think that an important lesson of last year’s GameStop Corp. meme-stock situation is that retail options weirdos are in fact the driving force of corporate finance, or, at least, that retail options trading is a key part of being a meme stock.
“If everyone buys short-dated out-of-the-money call options at once, the stock will go up,” was an important explicit thesis of the Reddit WallStreetBets GameStop enthusiasts. So they all bought call options, and the stock went up. The theory here — the popular term for it is “gamma squeeze” — is that when retail traders buy call options, the options dealers who sell them the options hedge by buying some of the underlying stock. This makes the stock go up. Often, the dealers spend more money on the hedge than the retail traders spend on the option, meaning that buying an option gives you more bang for your buck — makes the stock go up more — than just buying the same dollar amount of stock would have. Also, as the stock goes up, the options dealers have to buy even more stock to adjust their hedges, in a self-reinforcing cycle.
This theory is not right in every particular, dealers’ hedging can also push the price back down, and there is some debate about how much of this stuff actually occurred, or mattered, in GameStop’s wild week last January. But the point is that an army of small retail investors YOLOing options to make a stock go up is an important part of meme-stock mythology now, and GameStop at least suggests that it can work.
Tesla Inc. is in some ways the original meme stock, and Redditors were pushing the gamma-squeeze perpetual-motion theory of Tesla at least as far back as early 2020. The stock is up about 580% since then. And now Tesla’s stock is very expensive, so its options are presumably out of reach for some Redditors; splitting the stock will allow more retail traders to YOLO more options, which will create more Reddit-y retail enthusiasm, which should be good for the stock.
More generally the point that I want to make here is that corporate finance in 2022 is about at least four things:
- Doing good business stuff, investing money in business projects that have positive expected value, etc.
- Doing good capital-structure stuff, making sure that you will be able to pay your liabilities when they come due, etc.
- Appealing to institutional investors with good disclosure, friendly investor-relations professionals, good environmental, social and governance behavior, etc.
- Appealing to retail investors with memes, crypto, Teslas, easily YOLOable options, etc.
If you make it easier at the margin for your stock to become a meme stock, then the chance of your stock doubling for no reason goes up from, like, 0.1% to 0.3% or whatever. (The baseline probability for a giant liquid company is pretty low — it seems unlikely that Apple Inc. will become a meme stock? — but Tesla really is both huge and meme-y so you never know.) The appeal of your stock to a fundamental institutional investor goes from “our cash flows are solid, etc.” to “our cash flows are solid, etc., and also you get a lottery ticket on meme-stock enthusiasm.” That should make the stock worth more, even now, to everyone.
Even more generally. There is a view of the stock market that is like:
- A share of stock represents fractional ownership of a real business.
- In the long run, the value of that share is equal to your share of the free cash flow of that business.
- The stock price today represents some sort of composite estimate of that future free cash flow.
- At any given time, that estimate will probably be wrong for various reasons, but those reasons are all bad. They represent ignorance and irrationality and inefficiency.
- In the long run the bad reasons wash out and the stock is worth its fundamental value.
But the central argument of the meme-stock era is:
- No, a share of stock represents a token that people can trade for money.
- In the long run, it is worth what people will pay for it.
- Things that increase the attractiveness of buying it make it more valuable in the long run.
- For various reasons (tradition, the market for corporate control, etc.), increasing the cash flows of the underlying company is a very important way to increase the attractiveness of buying the stock, but it is not the only one.
- Giving the stock a more appealing ticker symbol, for instance, adds value.
- Giving away free popcorn with every stock purchase, why not.
- Having a fun online community of people talking about the stock.
- If the CEO is funny online that definitely helps.
- Sure, make it easier to YOLO options.
That is, the “non-fundamental” things about a stock are not just unpredictable noise; they are real facts about the stock market, investors can try to anticipate them, and companies can try to control them. You can build a corporate finance strategy around memes. If splitting your stock makes your stock go up then you should split your stock, not because that will maximize your long-term free cash flow but because it will maximize your stock price. Those are different things!