What Does Netflix Inc's 7-for-1 Stock Split Really Mean?

By Markets Fool.com

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Netflix has done it. Two weeks ago, the digital video veteran asked shareholders to approve a 30-fold increase in the number of authorized shares. The proposal was approved by 60% of shareholders, and here's the result: a seven-for-one stock split.

On July 14, each Netflix share will pay a one-time dividend consisting of six additional shares. Technically, you should hold shares at the close of July 2 in order to qualify for this event, but shares traded between those dates will automatically come with a due bill. That's an IOU that requires the seller to hand over the new split-based shares to the buyer as soon as they are created. All of this is handled by the brokers behind the scenes, so there's no way to sell your shares and hang on to the stock dividend.

Netflix shares rose nearly 3% on the news, setting the stock up for another all-time record price, and adding more than $1 billion to the stock's total market value.

Investors clearly love stock splits, and welcomed this one with open arms. But what's the big deal? Let me give you the lowdown on what stock splits actually do for investors -- and what they don't do.

Nope. Nuh-uh. No way.
First of all, stock splits don't really create market value. You might think that a sevenfold increase in Netflix's number of shares might also increase the stock's total market value. That's just mathematics, right?

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Well, no. Netflix isn't printing dollar bills here. Instead, it's dividing the same $41 billion asset into seven times more slices. It's like splitting a $100 bill into five $20 greenbacks. More paper in your wallet, but the same total value.

You could also imagine that a lower-priced stock can rise faster and easier than a high-priced one. This is certainly true when you're looking at market caps and enterprise values: A small company can move faster up (or down!) than a large one.

But as we already established, stock splits don't enter into that equation. Share prices drop drastically overnight, balanced by an equally sharp increase in the number of shares. Net effect on market caps: zero.

It's also true for valuation metrics. Netflix shares currently trade at 180 times trailing earnings, which is enough to give value investors a heart attack. Once again, the stock split reduces both share prices and earnings-per-share figures sevenfold. After the split, Netflix will still trade in the same nosebleed territory.

And there's no evidence that low-priced stocks with large market caps would behave any differently on Wall Street's trading floors than an equally large company with a higher share price. Penny stocks jump and dive like (un-)synchronized swimmers, but not because of the low dollar value assigned to each stock stub. They make wild swings because the whole enterprise is vanishingly small and difficult to analyze. Netflix doesn't play in that league at all.

This seven-for-one stock split will not, cannot, and shall not change the value of your Netflix holdings. There's no mathematical miracle taking place here, and whatever value we Netflix investors might gain from this event must depend on other effects.


Image source: Netflix.

The Real World: Wall Street
What will this stock split do in the real world? Here are some of the actual effects that may or may not make a difference to Netflix investors.

For the most part, it's not about increasing share price. Instead, this move lets investors manage their holdings with a lighter touch.

All per-share figures will forevermore be divided by seven. This will shrink the range of analyst estimates and reported results, diminishing the headline impact of earnings reports.

For example, in last year's second-quarter report, Netflix presented earnings of $1.15 per share while analysts had expected $1.16 per share. That's a $0.01 miss.

If Netflix had split its shares seven-for-one before that report, you'd be dealing with both estimates and reported earnings at $0.16 per share. Or the earnings surprise of $0.31 per share in the recently reported first quarter would have been a $0.04 outperformance. Rounding errors would move that 45% surprise to 55%. So the earnings beat looks smaller on the dollar-value surface, but bigger in percentage terms.

All of these transformations are full of sound and fury, signifying nothing. This exercise only underscores the loose mathematics investors have to deal with all the time. Everyone is shooting from the hip, and more decimal points just leave more room for speculation and errors. That's especially true for forecasts, and will remain so until a flawless crystal ball hits the market.


Image source: Netflix.

Where was I? Right: Real results from this stock split. There are a few more.

Investors with very small budgets can soon afford to grab a slice of Netflix. At nearly $700 per share, Netflix may have priced itself out of reach for really tight investing budgets. A new $100 share price should allow very restricted portfolios to join the market action.

Moreover, some brokers charge higher fees for very small transactions. Some prefer so-called "whole lots" -- or batches of 100 shares per trade. Standard stock options also represent either 10 or 100 shares per contract. On that scale, the minimum Netflix investment just dropped from $70,000 to $10,000. That's the difference between a fully loaded German luxury sedan and a rusty second-hand clunker. High share prices can indeed keep some investors out of the market, and stock splits work around that problem.

But do watch out for commission fees if you're playing on that level. Most online brokers charge between $5 and $10 per trade. Buying one $700 share of Netflix works out to between 0.7% and 1.4% of the total trade, which isn't horrible.

But buying a single $100 share comes with between 5% and 10% in trading fees. That's a steep cut, taken right out of your overall returns. So if you really want to buy a single $100 Netflix share per month, it's still a good idea to save up for a while, and then grab several low-priced shares for a single commission fee. In terms of making the most of your investing assets, this seven-for-one split doesn't really help much.

You do get more fine-grained control over your Netflix holdings. Buying $1,000 worth of Netflix currently amounts to a share and a half. You won't find many brokers willing to handle that trade. Soon, it will be a simple 10-share lot. I can't think of a case where this subtle modification really matters to your long-term results, but I'm sure they exist.

Finally, a lower share price may actually help Netflix in some very specialized situations.

Remember how Apple performed its own seven-for-one split, and then joined the prestigious Dow Jones Industrial Average? The Dow move would never have happened without the stock split. We're talking about a price-weighted index, which means that high-priced stocks move the Dow further and faster than low-priced ones. Without that split, the Dow would have been dominated by a bulky Apple stock.

I'm not saying that Netflix belongs on the Dow yet. Today, it would be the second-smallest Dow member counting by market cap. Splitting the stock is not a guaranteed ticket to Dowsville.

Do come back in a few years, however, when Netflix's international expansion plans have played out. The media industry is under represented on this popular index, and Netflix may one day earn a space there. It might take another split at that point, but the 30-fold share authorization leaves room for that.

The fine-grained nature of a higher share count also makes a difference to share-based buyouts. For example, Berkshire Hathawaysplit its Class B shares 50-fold when it bought national rail carrier Burlington Northern Santa Fe. That split shielded many Burlington shareholders from a forced, taxable sale if their holdings didn't add up to a full Berkshire B stub.

Netflix isn't known for its large buyout appetite;but you never know. This effect might come into play one fine day. Just don't hold your breath.

Perception is reality
At the end of the day, Netflix's stock split is a show for the gallery. There's psychological value in having a low share price. Small investors don't get intimidated, and larger investors might even see an illusory discount. Hey, we're all human (except for the robo-traders).

If nothing else, it's a vote of confidence from Netflix, its management, the board of directors, and the shareholders who approved the share increase. It's the opposite of a reverse split, which is a move invoked only when stocks are in deep trouble, and may fall below the market's listing thresholds.

A company would also look silly to push through a stock split, followed by an organic price drop. Netflix is telling the world that the future looks solid, with agreement from all the stakeholders I just listed. And that's worth something, right?

The article What Does Netflix Inc's 7-for-1 Stock Split Really Mean? originally appeared on Fool.com.

Anders Bylund owns shares of Netflix. The Motley Fool recommends Apple, Berkshire Hathaway, and Netflix. The Motley Fool owns shares of Apple and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.