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Effects of Stock Effects of Stock Splits on Splits on Splits on Return And ) EFFECTS OF STOCK SPLITS ON RETURN AND LIQUIDITYLIQUIDITY:: A STUDY ON TECHNOLOGICAL COMPANCOMPANIESIES GEHINI JOSHI ANR: 178628 MSC in Finance Supervisor: Alberto Manconi - 2014 - EFFECTS OF STOCK SPLSPLITSITS ON RETURN AND LIQUIDITYLIQUIDITY:: A STUDY ON TECHNOLOGICAL COMPANCOMPANIESIES Master TThesishesis Finance School of Economics and Management Tilburg University GEHINI JOSHI ANR: 178628 Supervisor: Alberto Manconi 1 AbAbAbstractAb stract This thesis examines the effects of stock splits made by technology companies listed on AMEX/NYSE and NASDAQ. Prior studies suggest that managers use stock splits to convey favourable information, improve liquidity and bring price back to normal trading range, and to broaden the shareholder base. I analyse splitting companies before and after stock splits. The results show that an increase in return, profitability, and liquidity in the year after the split. These findings strongly support the signalling and liquidity hypotheses. However, in contrast to the previous studies, I do not find any support for the trading range or the shareholder base hypothesis. 2 AAAcknowledgementsAcknowledgements Along the journey of my studies in Tilburg University, I have been supported and inspired by many people. I would like to take this opportunity to express my thanks to all people who have helped me to complete this thesis. First of all, I would like to thank my thesis supervisor Alberto Manconi for his invaluable suggestions and insightful comments during the time of my thesis. I would like to acknowledge my family in Nepal for their emotional support and motivation. Special thanks go to my friends for their inspirational words. Finally, I would like to express deepest gratitude to my husband Rameswor and son Ruben for their immense support, understanding and patience. Their continuous support in pursuing my study is invaluable to me, for which I am eternally grateful. 3 TablTablee of Contents 111 Introduction ................................................................................................................................................................................... ................... 666 222 Literature Review and Hypothesis Development ........................ 101010 2.1 Trading Range Hypothesis ............................................................................ 10 2.2 Liquidity Hypothesis ..................................................................................... 12 2.3 Signalling Hypothesis .................................................................................... 13 333 Methodology ................................................................................................................................................................................ ................ 161616 3.1 Description of Data ........................................................................................ 16 3.2 Research Method............................................................................................ 17 444 Results ................................................................................................................................................................................... ............................... 232323 4.1 Descriptive Statistics ..................................................................................... 23 4.2 Test of the Trading Range Hypothesis.......................................................... 24 4.3 Test of the Liquidity Hypothesis ................................................................... 25 4.4 Test of the Signalling Hypothesis ................................................................. 26 4.5 Market Reaction to Stock Splits .................................................................... 27 4.6 Sensitivity Analysis ....................................................................................... 28 555 Conclusion ................................................................................................................................................................................... ................... 292929 666 References ................................................................................................................................................................................... ..................... 313131 4 List of TTablesables Table 1: Descriptive statistics ............................................................................................34 Table 2: Stock split factor by year ......................................................................................35 Table 3: Test of the trading (price) range hypothesis ........................................................36 Table 4: Test of the liquidity hypothesis ............................................................................37 Table 5: Test of the signaling hypothesis ...........................................................................38 Table 6: Market reaction to stock splits on the day of announcement and execution ......39 Table 7: Sensitivity analysis of announcement return on different event windows .........40 List of Figures Fig 1: Time line for Event Study ........................................................................................41 Fig 2: Histogram of stock splits of Technology Company stocks in the period of 1995 to 2013 .....................................................................................................................................41 Fig 3: Plot of average abnormal return around the event day ..........................................42 Fig 4: Cumulative average abnormal return around the event day ..................................43 5 1 Introduction Recently, major technological companies such as Google Inc. (GOOG) and Mastercard Inc. (MA) announced stock splits. Share prices were up 0.5 % and 2.5% respectively hours after the announcement 1, 2. Both companies completed stock splits for the first time in their company history. Apple Inc. (AAPL) also completed a seven for one stock split this year for the fourth time. This means that every Apple stockholder receives six additional shares for every share he owns. This distribution cut Apple’s share price down to $92 from $645, but increased the number of outstanding shares from 861 million to 6 billion. On the day of the split announcement, Apple shares went up by 8%. The Apple managers said they want to make the stock more accessible to the average investors, and the early months’ return is impressive. (Source: online.wsj.com) Stock splits are “cosmetic” corporate events. The effect is to bring stock prices down and increase the number of outstanding shares, without changing the market capitalization. For example a company has 1 million shares outstanding which are trading for $200 each and the total market value is $200 million. If the company announces two-for-one stock splits, the outstanding number of shares will increase to 2 million while the par value of stock drops to $100. Thus, the stock split per se does not create intrinsic value to the company. Similarly, it does not affect the value of investors’ holdings. It merely cuts the “pie” into smaller slices. In theory, stock splits should have no impact, but in practice corporate managers view stock splits to be more than cosmetic accounting. When companies do split their stocks, the interesting question may arise: why? The literature has put forward three 1 http://www.businessinsider.com/5-things-to-know-about-apples-stock-split-2014-6 2http://www.forbes.com/sites/samanthasharf/2013/12/10/mastercard-announces-10-for-1-stock- split-plans-to-return-cash-to-shareholders/ 6 possible explanations, the trading range hypothesis, the liquidity hypothesis and the signalling hypothesis. The trading range hypothesis suggests that firms use stock splits to realign the share price to a preferred price range, so that it is more affordable to individuals as well as institutional investors. Keeping the stock within the normal price range attracts a larger ownership base, improves liquidity and reduces trading cost of the stock. The liquidity hypothesis argues that firms tend to split shares to increase the liquidity of their shares. A lower share price is attractive to the investors, which creates more buying and selling activity. The signalling hypothesis suggests that managers use stock splits to signal positive information about a firm’s future expectations. Abnormal returns observed around the split announcements provide better estimates of company prospects. Prior studies conclude that splitting firms do better compared to non-splitting firms. The market generally reacts to stock splits as good news. Stock splits are a signal from management that their company’s share price continues to appreciate and improve profitability. If managers believe that there is a significant probability of a price increase they will split the shares and keep price within the trading range. Previous studies have found a significant positive market reaction to stock split announcements. Grinblatt, Masulis, Titman, (1984) argue that stock splits convey information about the current value and future prospects of the splitting firms. There is information asymmetry between managers and shareholders. By splitting shares, managers lower the information asymmetry. Ikenberry, Rankine and Stice (1996) claim that stock splits send positive signals to the market that the firms are confident in the growth of their future earnings. Desai
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