Stock splits don’t affect company’s value

Do you get excited over stock splits? Don’t — because they’re largely meaningless.

Imagine shares of Cheese Sciences Inc. (ticker: CURDS), trading around $40 each. If you own 100 shares, they’re worth about $4,000. If CURDS splits its stock 2-for-1, for each share you own you get another. With 200 shares, are you now a lot richer? Nope. While the number of your shares increases, the value of each share decreases proportionately. After the split, the shares will trade around $20 each. The total value of your shares? Still $4,000.

Splits can take many forms: 2-for-1, 3-for-2, etc. There are even “reverse splits,” which reduce the total number of shares and plump up the price. But beware — companies often use them to give the (false) impression of higher value. Remember, splits don’t affect the value of a business. They don’t change how much money a company makes.

One reason companies split their shares is to keep prices low enough for individual investors. If, in its 86-year history as a public company, Coca-Cola had never once split its stock, one share would be currently priced at more than $200,000. Few folks today could afford a single share. In fact, Coke has split so often in its history that if you’d bought just one share when it went public in 1919, you’d have more than 4,600 shares today. It’s rare for investors to be shut out of a stock because of a steep price, though. Even with a $500 stock, shallow-pocketed investors can just buy one or two shares.

While a split can make a stock’s price more psychologically inviting, it doesn’t make it a sudden bargain. A stock selling at more than $100 per share might seem “expensive,” but it can be a much better value than many $20 stocks. Stock prices matter only when you compare them to other numbers, such as earnings.

Focus on companies’ true value, not their stock price. Try our “Inside Value” newsletter for free, and see which stocks we think are undervalued at www.insidevalue.fool.com. Or read “Value Investing for Dummies” by Peter J. Sander and Janet Haley (Dummies, $22).

Ask the Fool

Q: What’s the “rule of 72”? — P.W., Sacramento

A: It’s a tiny bit of math that can help you think about investing. The rule offers a quick way to figure out how long it would take for an investment to double in value at a given growth or interest rate. For example, imagine that you have some money to invest and are deliberating between plunking it in stocks (expected average annual return: 10 percent), CDs (5 percent) or a savings account (2 percent).

Take 72 and divide it by 10, and you’ll get 7.2. That means it should take about 7.2 years for your money to double, growing at 10 percent. Divide 72 by 5, and you’ll see that it’ll take about 14.4 years to double your money at that rate. Growing at 2 percent, doubling will take about 36 years. The rule can be reversed, too. If you know that your money doubled in four years, for example, you can divide 72 by 4 and you’ll see that you earned roughly 18 percent per year.

The rule of 72 doesn’t work, though, when you’re dealing with extreme numbers. Divide 72 by a 72 percent return, for example, and you’ll see that you can expect to double your money in one year. But that would actually take a 100 percent return, not 72 percent. In addition, it’s more accurate when dealing with somewhat higher returns to use 76, not 72.

Q: What are basis points? — K.S., Sioux Falls, S.D.

A: Basis points are 1/100ths of a percentage point and are often mentioned in relation to interest rates. So if you hear that something is down 50 basis points, that means it’s down half a percentage point.

My dumbest investment

My stock club is doing pretty well now, but we’ve definitely committed some errors. Buying McLeod soon after it went public wasn’t dumb; the stock doubled and then tripled in value. But holding on to it as it plummeted until we finally sold at around 30 cents per share — that was dumb. (We’d bought at about $17 per share.) We did the same thing with Engineering Animation. We even bought more shares as it began to drop, thinking that it had such good products that it would come back up. We rode that horse all the way down ‘til it died at the bottom of a ravine. — Kris, Iowa City, Iowa

The Fool Responds: You’re smart to belong to an investment club — they can help investors of all stripes perform better (learn more at www.better-investing.org and www.fool.com/InvestmentClub). At least you sold your McLeod shares for 30 cents — they fell even lower later. Ask yourself how much your club really knew about the company. Many fallen stocks recover nicely, but hang on only if you’re informed and confident.