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What is a Stock Split, and Why is Facebook Planning One?

Facebook (NASDAQ: FB) has been making headlines after it announced plans for a 3-to-1 stock split and the creation of class C shares.

In this episode of Industry Focus: Tech, Sean O'Reilly and Dylan Lewis explain what investors should know about stock splits, take a closer look at Facebook's proposed plan, and explain why investors that love Mark Zuckerberg should love the move.

A full transcript follows the video.

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This podcast was recorded on May 6, 2016. 

Sean O'Reilly: Stock splits are debatable no matter how you slice it, on this tech edition of Industry Focus.

Greetings, Fools! Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. It is May 6th, 2016. Friday! TGIF! In the studio with me to talk about all things tech, as always, is Dylan Lewis. What's up, man?

Dylan Lewis: Not too much, Sean. Nice to be back. We had a little break last week, because I was hosting with Nathan on the show.

O'Reilly: How'd you do with the chair switch?

Lewis: I sat in your chair, the host chair, and he sat over here.

O'Reilly: Was it weird?

Lewis: It was different.

O'Reilly: Good show, by the way.

Lewis: I realized the camera was getting my right side rather than my left side.

O'Reilly: Is that your better side?

Lewis: I don't know, you'd have to ask the viewers.

O'Reilly: Write to us at IndustryFocus@Fool.com to tell us which side (laughs) is Dylan's good side.

Lewis: There it is, the email plug. Now we can get on with the show.

O'Reilly: We're talking about not necessarily a tech theme today, but, it obviously affects a couple of tech companies, which we'll be talking about. We're talking about stock splits. Dylan, for our listeners who may not know, what is a stock split?

Lewis: A stock split is basically, if you think about a company's value and their ownership as a pie, stock splits take that pie, and, if it's cut into 1/8ths to start, it cuts it into 1/16ths.

O'Reilly: What kind of pie is it?

Lewis: I like to think it's a pecan pie.

O'Reilly: Pecan pie. (laughs) 

Lewis: So, if you owned 1/8th of that pie, and it was a two-for-one split, you would now be getting two slices of 1/16th pie. 

O'Reilly: (sighs) Why do people do this, Dylan? (laughs) 

Lewis: There are a couple different reasons companies do it. Some of them I put credence in, and some of them I don't, personally. But the idea here is, you're making your shares slightly more accessible to the average investor, because the overall value of the company doesn't change, and you're just getting smaller slices. Say you're currently trading at $100 a share. If they do a two-for-one split, they're now trading at $50 a share, and you have two shares in your account.

O'Reilly: What's your opinion on that? Everybody's favorite example of this is Warren Buffett's Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). Not everybody has $200,000 to just buy one share of something. What do you think about that?

Lewis: I think there's something to be said for keeping your share prices high, and having people who are buying and holding and not moving in and out of positions. I think it does attract a certain type of investor. I do think it's a nice when companies decide they want to make their shares more accessible to the average investor. Tim Cook, when Apple split seven-for-one, said, "We're taking this action to make Apple stock more accessible to a large number of investors." He made it plain and simple that that was part of the motivation for it.

One of the other things people will cite is, it does increase liquidity, if for some reason you're seeing wide bid-ask spreads -- what people are willing to sell for versus what people are willing to buy for in brokerage accounts, or the brokerage teams that pair those up. You'll see those spreads tighten up.

O'Reilly: That seems like kind of a dubious claim today, because of the proliferation of technology in the financial industry. All trading is done by algorithms.

Lewis: Especially because most companies that are splitting, already have a pretty big daily active volume, and it's not something that will dramatically change that. So I don't know how much I believe that. But, the last line of thinking -- and, again, this is one that is not super relevant, maybe, as much anymore, but board lot thinking and the strategy there. A board lot is the standardized number of shares as defined by a stock exchange as a trading unit. Basically, you think about some of these big institutional moves and brokerage moves that happen. The purpose of these board lots is to avoid odd amounts of shares. If everyone is working in these 100 share denominations, typically, then you won't wind up with these weird 83 share lots that no one wants. It makes it easier to get a collection of 100 shares for that board lot if the share price is lower.

O'Reilly: Got it. Seems like that would have been more of a problem 30 years ago, again.

Lewis: Right. I actually have a great data point and some questions to ask that tie into that a little bit. This is kind of an interesting data point I came across in researching this show. From 2008 to 2013, only twelve S&P 500 companies on average split their stocks each year. This is data coming from S&P Dow Jones indices. By comparison, in the 90s, an average of 64 companies in the S&P 500 split their stocks each year. In 1997, there were 102 total stock splits.

O'Reilly: Wow. The proof is in the pudding, yeah.

Lewis: I have a couple theories as to why stock splits are going down. Before I name any of them, Sean, do you have any guesses or thoughts?

O'Reilly: I peeked at yours, they're very good. The other theory I have is, Warren Buffett has become a huge part of the American nexus, and he's become increasingly influential in the last 20 years, with all these books, and he's just everywhere. He's basically a household name now. Another instance where he kind of said this was silly was tech companies, in the early 2000s, and actually Coca-Cola too, they weren't expensing stock options on their income statements. They were giving millions of dollars to employees, but they weren't expensing them on income statements, and Buffett was like, "That's silly. It's hard to calculate the value, I'll grant you, and that's fine."

Lewis: "But you need to account for that somehow."

O'Reilly: Yes. And not only did Coca-Cola, which he owns 9% of, do it -- and that was actually the first S&P 500 company to expense stock options, I believe. If it wasn't the first, it was one of them. But, he actually got his buddy, Bill Gates, to do it at Microsoft (NASDAQ: MSFT). They were the first big tech company. So, I couldn't prove it, but I would throw out Buffett being part of the American nexus and his thoughts on the matter. He does not believe in share splitting, he wants long-term partner shareholders. I would throw that as a hare-brained theory of mine. (laughs) 

Lewis: A couple thoughts I had on it. One of them, you look at the time frame this was cited -- and I grabbed this from a Wall Street Journal article -- that 2008 to 2013 range, that's mid- to post-financial crisis.

O'Reilly: They were doing reverse stock splits, more likely. (laughs) 

Lewis: Yeah, you might just see companies wanting to stay stable, and not rock the boat with anything crazy on the corporate governance side. One of the other things, I think, to your point about technology, you have online discount brokers, which make building positions much cheaper. You look at some of the very expensive tech stocks right now, like Google (NASDAQ: GOOG) (NASDAQ: GOOGL). If you want to buy one or two shares, right now, you can do it and pay a $7 commission. The expenses are not a huge portion.

O'Reilly: Right. In fact, that's $7 flat, so it doesn't matter.

Lewis: Right. Whereas, maybe in the early 90s or so, the cost of making those types of trades and position building and dollar-cost averaging was a little bit more expensive. The one other thing I think might be contributing, maybe not quite as much, is the widespread availability of fractional shares. The idea that people do not need to buy an entire share of Google. There are a whole bunch of platforms out there where you can buy parts of a share of Google.

O'Reilly: The wonders of modern technology.

Lewis: Yeah. So, those are some of the reasons I see. I think, largely, companies are not as tied up in the idea of making it as accessible to buy shares. I think there's something to that idea of building more of this buy and hold company type pressure. That's what Alphabet did. That's what we're moving toward. And there's a lot of Buffett influence there.

O'Reilly: When do you think investors should care about a stock split? When will it affect their lives?

Lewis: To go back to that metaphor, the pie is the same size, and you're just slicing it differently, and you're owning that same portion. Sometimes, there are instances where it's not just--

O'Reilly: One of the slices gets to vote a lot. (laughs)

Lewis: Basically, you wind up in these situations where, "We're slicing the pie differently, but I'm telling you what the pie's going to look like." (laughs) Or, "I'm going to tell you what the pie is made out of."

O'Reilly: (laughs) "One of the slices has all the pecans."

Lewis: Yeah. You're seeing a couple really high profile examples. Under Armour is one in the tech space. But, some stock splits, more recently, have been used to issue new share classes. And those new share classes distribute the economic value of the split, but they don't necessarily have the same rights as the previous shares did. Our lead-in for the show, and why we wanted to talk about this, is Facebook's proposed split. This is something that came up in their conference call. If you checked out Facebook's conference call, you would have heard, "Pending stockholder approval. We intend to issue two class C shares as a one-time stock dividend for each outstanding class A and class B share, resulting in a tripling of the pre classification total shares outstanding."

O'Reilly: Hmm.

Lewis: That's from David Wehner, the CFO of the company.

O'Reilly: Who owns all those class B shares, Dylan?

Lewis: (laughs) You want to take a guess?

O'Reilly: Oh, I know who. (laughs) 

Lewis: (laughs) Yeah, so, right now--

O'Reilly: His name rhymes with Muckerberg. 

Lewis: Facebook already has two classes of stock, A and B shares. They were created when the company went public. The idea there was, they wanted Mark Zuckerberg to retain ownership of the company. Class A shares each have one vote. Mark Zuckerberg owns a pretty small percentage of them, actually, I think about 4 million of the 2.3 billion outstanding. Tiny. Class B shares, on the other hand, have 10 votes each. He owns 468 million of the roughly 550 million outstanding.

O'Reilly: Yeah.

Lewis: So, 85%. All told, he owns about 15% of the company, but wields like 60% of the votes.

O'Reilly: The proposed issuance of the two class C shares and everything, pending stockholder approval, that's definitely going to happen, because he controls 60% of the voting power of the company.

Lewis: It will probably happen, yeah. It'd be crazy for it not to.

O'Reilly: Unless he accidentally hits the NO button or something.

Lewis: So, how does this all tie in? Again, from the company's conference call, "This structure will allow for the preservation of the voting structure that has served the company well today, while allowing Mark to fund the Chan Zuckerberg Initiative over the course of his lifetime. Importantly, as part of this proposal, the preservation of the multi-class capital structure would generally be predicated on Mark continuing to maintain an active leadership role in Facebook." For listeners who might not know, the Chan Zuckerberg Initiative is Mark and Priscilla Chan, his wife, LLC. It's not a non-profit, but it is slanted toward a non-profit type mission. The idea there is advancing human potential and promoting equality in areas such as health, education, scientific research, and energy.

O'Reilly: He's more or less doing what Gates did, just a little bit younger, with the Bill and Melinda Gates Foundation.

Lewis: Exactly. So, earlier in the year, they committed to donating 99% of the value of their Facebook shares. He said he's not going to sell more than 1 billion over the next three years, but for him to do that, based on his current ownership, he'd hit a point where he'd be selling very valuable shares.

O'Reilly: In terms of voting rights.

Lewis: Right. So, if you look at what is effectively a three-to-one split, he will be receiving a ton of shares, (laughs) over 900 million shares, to work with. He will then be able to transfer the non-voting class C shares to those--

O'Reilly: The foundation.

Lewis: The foundation, the LLC, and maintain that ownership. 

O'Reilly: Got it.

Lewis: And this is very similar to what Under Armour looked to do with their C shares. The idea there was, Kevin Plank is at the helm, and he wants to maintain ownership of the company. 

O'Reilly: It seems like companies wind up doing stuff like that just so the founder can spend some of their money. You look at Larry Ellison over at Oracle, he owns one of the islands of Hawaii, and he races super crazy yachts.

Lewis: Doesn't sound like he's giving 99% of his shares away.

O'Reilly: No. It was interesting to me, I don't think he's ever really sold his original shares in Oracle. But what he did, instead of doing different share classes or whatever, is he just gets a ton of stock options every year.

Lewis: Oh, he's written in crazy grants, right?

O'Reilly: Yeah. There's that, and then obviously, you have Buffett, who waited until he was 80 to start giving his money away, and then it doesn't matter. Really the only outlier there is Gates, that I can think of, because he's just selling his shares. He actually, it happened a year ago, Ballmer actually owns more of Microsoft than Gates.

Lewis: Wow.

O'Reilly: Isn't that crazy?

Lewis: Yeah, I didn't know that.

O'Reilly: I remember going to the library when I was like 16, and reading the Value Line investment survey, and one of the pages in it is major insider sells, and they send it out every month. Every month, like clockwork, for like 15 years, Gates has been selling 20 million Microsoft shares. Anyway, bottom line, stuff like this always kind of leaves a bad taste in my mouth.

Lewis: Yeah, there's that weird tinge of, "I know what you're doing, and I think it's right." Because, if you're on Facebook shareholder, you believe in Mark Zuckerberg, and you believe in his vision of the company, and you want him at the helm. I can't think of anyone else you'd rather have running that company. So, you want him locked up, and you want a corporate structure that gives him the opportunity to wield ownership as he sees fit, and steer the company toward the initiatives he wants to be working on. 

O'Reilly: On the other hand ... (laughs) 

Lewis: It does have that weird taste to it, though. If you own Facebook and you don't want Zuckerberg at the helm ...

O'Reilly: Why are you buying it?

Lewis: Yeah, why do you own them?

O'Reilly: It just seems to me, stuff like this, these complicated, convoluted ownership structures, long-term, they kind of muck things up a little bit.

Lewis: Yeah. And there has actually already been a class action lawsuit filed by a shareholder claiming that this moves gives Zuck--

O'Reilly: Did that happen about five minutes after this announcement was made?

Lewis: Yeah, it was (snaps) like that. They claimed the move gives Zuck entrenched control without him having to give up anything, and that's kind of problematic. And, from a corporate governance standpoint, I understand that argument. But, it's really one of those things where, if you believe in him as a leader, and you're following him as an investor, then you really shouldn't worry all that much about it.

O'Reilly: You also brought up a good point when we were walking down here. This also kind of protects them from crazy corporate raiders.

Lewis: Yeah.

O'Reilly: I appreciate that.

Lewis: If he maintains more than half of the voting rights for the company, he can pretty much do whatever he wants. You're not going to have someone really vocal like Ackman or Icahn come in and tell him what he needs to do.

O'Reilly: Right, and then they'll sell a year later, because I don't actually care about the long-term company or something.

Lewis: Yeah, and it's something they talked about a lot in the conference call, that they were making several long-term bets, and they feel a lot of the big risks they were taking, more of them are in front of them than behind them. And, having an entrenched CEO that is also someone who owns a ton of the company and can do what he needs to do, sets you up to make some of those bets and make you less subjected to these more short-term, medium-term mind-sets that are out there. 

So, people who are interested in following up on this, stay tuned. There's going to be a vote in the annual shareholder meeting on June 20th, and that will determine whether or not it passes.

O'Reilly: It will.

Lewis: I'm guessing it probably will. (laughs) But, more to come on that.

O'Reilly: To round things out, when should we not care about stock splits?

Lewis: Yeah ...

O'Reilly: Every other instance?

Lewis: Yeah, basically, when none of the above applies. If it's not materially changing the corporate ownership structure, if you are simply getting two shares of the same share class for one that you owned before, then it's probably not much of a big deal. Reading financial media stuff, I'm sure you see this too, I'll see things like, "Amazon should split its stock because it's expensive, and people should buy it."

O'Reilly: Do you feel richer with a $10 bill, or two $5s?

Lewis: Yeah. And you'll see the arguments that are like, "Well, psychologically, someone believes that a $100 stock could go to $200 much more easily than a $500 stock could go to $1000." It's like, well, that's not how growth works, you know? It's the same growth percentage either way. So, I don't know, I would just ignore that kind of noise.

O'Reilly: The only other time I could think of where it would matter was it was being done for reasons such as an acquisition. Berkshire Hathaway has class B shares that are 1/100th, so they're traded for $2,000-3,000, then class A is $200,000. And they were actually done so Berkshire Hathaway could buy ... American General Insurance? Anyway, they bought another insurance company in like 1999. It was a stock-for-stock deal, and they were like, "We can't chop up $100,000 share price," so they had to issue the class B in order to make that possible.

Lewis: Yeah, that's when you need it.

O'Reilly: But, obviously, the event there is the merger, not the actual split. Cool. Alright, Dylan, thank you for your thoughts.

Lewis: Always a pleasure, Sean.

O'Reilly: Have a good one. If you're a loyal listener and have questions or comments, we would love to hear from you, just email us at IndustryFocus@Fool.com. Again, that's IndustryFocus@Fool.com. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Dylan Lewis, I am Sean O'Reilly. Thanks for listening and Fool on!