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I recently read that Alcoa, a publicly traded company (AA), will soon split into two publicly traded companies.

While merging two companies makes sense to me, splitting does not. Merging companies leads to eliminating duplicated effort, reduced cost in management, ability to negotiate better deals, etc. Rationale for splitting reads like the opposite of those points.

A split like this sounds like an opportunity to take a profit center away from the larger company so that it is less encumbered by debt and market stagnation. So, the original company will continue business as usual and any shares that one holds in the original company will depreciate because it has lost a critical, profitable part of itself. On the other hand, the new company will see rapid growth.

How are shareholders insured to receive a fair percentage of each company so that growth in one will evenly offset the decline in the other? Or, maybe shareholders should quickly sell of their shares in one company or the other? Executives in the two new companies know very well the valuation of parts they now have, but it would seem difficult for new shareholders to have any idea until at least after quarterly results.

It's fairly easy to act on this as a trader, but probably not so for mutual fund holders or 401K type investors. Imagine an extreme scenario where the company is split into two and one carries all the profit and production, and the other carries all the debt and no production. A trader would immediately sell of shares on this news, but not everyone is actively managing individual stocks.

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How are shareholders sure to receive a fair percentage of each company? At the time the split occurs, each investor owns the same proportion of each new company that they owned in the first. What the investor does with it after that (selling one, for example) is irrelevant from a fairness perspective.

Suppose company A splits into companies B and C. You own enough stock to have 1% of A. It splits. Now you have a bunch of shares of B and C. How much? Well, you have 1% of B and 1% of C. What if all the profitable projects are in B? Then shares of B will be worth more than those of C. But it should be the case that the value of your shares of B plus the value of your shares of C are equal to the original value of your shares of A. Completely fair. In fact, if the split was economically justified, then B + C > A. And the gains are realized proportionally by all equityholders.

Remember, when a stock splits, every share splits so that everyone owns both companies in the same proportion as everyone else. Executives don't determine what the prices of the resulting companies are...that is determined by the market. A fair market will value the child companies such that together they are worth what the original was.

  • Are there laws in place to insure companies act fairly? Still thinking hypothetically. Company A has accrued lots of debt that is holding back overall growth. The share price is stuck at $10 a share. Company A has a division that is the only profitable part. The company splits into B and C with the intention of discarding all debt and liabilities to company C and then filing for bankruptcy. I don't know how company splits are valued, but I assume it is like regular stock splits. Shareholders would have equal number of shares in B and C at ~ $5 per share. C becomes worth $0. B + C < A – Michael Prescott Mar 21 '16 at 19:36
  • It isn't my intention to get stuck on the "fairness" of it. What I have in mind is that not everyone is actively watching the activities of every company that their 401K may be invested in or even the composition of ETFs. So, without some rules, there seems to be some risk of... manipulation for lack of a better term. – Michael Prescott Mar 21 '16 at 19:39
  • The problem with your question is that it assumes that the shares of B and C are worth $5 a share. This is not the case. Management cannot control this price. It just splits the stock and the price of the resulting child stocks is set by the market immediately to reflect true valuation. If the company is able to stuff its debt in one child company and then let it go bankrupt (which I doubt the SEC would let them do), then the actual result would be B + C > A because bankruptcy law has allowed equityholders to steal wealth from debt holders. – farnsy Mar 22 '16 at 18:11
  • When stocks simply split without a change to the company, the resulting child stocks are equal in value because they are indistinguishable. That is not the case when a company splits into two and creates two new and different stocks. That's why your assumption that company splits are valued like stock splits is incorrect. – farnsy Mar 22 '16 at 18:14
  • Thanks that clarifies it a lot better. I had the wrong impression from an article that I read that a company could determine how to divide shares and set the value. Without some disincentive, a company splitting up might say "ok, share holders get 1 share of the profitable company and 99 of the bankrupt company for every 100 shares they have in the original company" Even if that occurred, the valuation of 1 might go to $0 and the valuation of the other would offset the loss. The disincentive being, that the SEC wouldn't allow a company to discard debt like that. – Michael Prescott Mar 23 '16 at 16:50

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