Recently AAPL ran up on the speculation that company would split its stock, thus making it a candidate to be included in the Dow Jones Industrial Average (DJIA). For traders and investors it is important to understand the implications of AAPL split and its affects on Dow Jones Industrial average in case AAPL is added to the Dow Jones.
Before we dwell on the affects of AAPL on Dow Jones we need to understand the composition of Dow Jones Industrial Average, how it is weighted, which stock is highly likely to be replaced by AAPL, how the stock split works and what are the likely scenarios of AAPL stock splits.
DJIA is composed of thirty (30) actively traded blue chip stocks. These stocks and their weight in the index is also shown in the table below:
|No.||Stock Name||Symbol||% Weighted in the Index||Cumulative %|
|11.||Johnson & Johnson||JNJ||4.02||60.00|
|12.||Proctor & Gamble||PG||3.73||63.73|
|22.||JP Morgan Chase||JPM||2.07||91.29|
|30.||Bank of America||BAC||0.42||100.00|
Various indexes are weighted either based on price or market capitalization. Dow Jones Industrial Average is weighted according to price whereas S&P is weighted based on market capitalization.
What is Price-Weighted Index?
A stock index in which each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing them by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.
As you can see in the table above, as of this writing (July 31st, 2012), IBM has the most weight (11.43%) in the index as it is the highest price stock in the index. Second in line is Chevron and at the bottom of the list is Bank of America with a weight of 0.42 percent. Therefore, the movement of IBM stock up or down has more affect on DJIA than the movement of BAC.
IBM current price is at $198.52 and AAPL current price is $615.70. Therefore, if AAPL is added in DJIA then AAPL’s weight would be over a quarter of the entire index and will defeat the purpose of the index. Inclusion of AAPL in DJIA means that as AAPL moves up or down the Index would move up or down significantly.
Which Stock AAPL Could Replace?
Since there could be only thirty stocks in DJIA then one of the stocks has to be dropped. Which stock would that be? There are two likely candidates. HPQ and KFT.
If you look at the table above you will see that there are five tech stocks in DJIA. These are IBM, HP, Microsoft, Intel and Cisco. Out of these five companies HP is the most direct competitor of AAPL and Apple’s market capitalization at this point is almost 16 times that of HP. In this year AAPL is up nearly $203, whereas HP is down $7.25. If AAPL was part of DJIA (without any stock splits) then DJIA would have been higher by almost 1600 points and would have been trading above 14,600 which is above the all-time record high on the DJIA of 14,198 on October 9, 2007. If AAPL is included and HP is not replaced then DJIA will be heavily weighted by technology stocks. Since all stocks in one sector tend to move in tandem therefore, six stocks will even have a higher affect on DJIA.
The second candidate is KFT which is spinning off later this year into two separate companies. One will be named as Mondelez International and will market its famous brands such as Cadbury chocolate and Oreo cookies. The original company will retain its grocery business and will market products such as macaroni and cheese, cream cheese, coffee etc. Because spinoff will create two smaller companies and KFT’s rank is already number 20 in the DJIA therefore, after the spin off KFT price will go down further. Therefore, KFT could also be a candidate for replacement in case AAPL is added in the DJIA.
The third scenario could be that both HP and KFT are removed from DJIA and besides AAPL another company is added in the DJIA. AAPL would replace HP and KFT will be replaced by another company.
However, inclusion of AAPL in DJIA, at current price of $600, has very slim chance of being included as DJIA is price-weighted index. Therefore, AAPL has higher chance of being included in S&P index which is based on market capitalization.
One way AAPL could be added in the DJIA is if AAPL decides to go for split such as 2-1 or 3-1 or even 4-1. In the past AAPL had done the split three times each time it was 2-1 and these splits were on June 1987, June 2000 and February 2005. However, if AAPL does the split 2-1 this time even then AAPL would be the most heavily weighted stock in DJIA with a weight of 15.4% out ranking IBM which stands at 11.43%. If AAPL decides 3-1 split then AAPL weight would be 10.8% – 2nd in rank and in future if AAPL price moves up it can become number 1 in rank in DJIA very easily. Since AAPL is the largest company in the world by market capitalization out distancing Exxon Mobil by $170 billion, its products are loved all over the world, therefore, it makes sense for AAPL to just split in 2-1 ratio and therefore, makes itself eligible to be included in the DJIA and at the same time to be number one in DJIA. Even if AAPL splits 3-1 it will be second and could overtake IBM in near future. Therefore, the logic dictates that AAPL will not go for more than 3-1 split. Another factor which favors AAPL to be included in DJIA is its recent decision to pay dividend as other components of DJIA are dividend paying companies.
What is Stock Split and the Performance of Stock such as AAPL After the Split
All public-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision by the company’s board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders. For example, in a 2-for-1 stock split, every shareholder with one share is given an additional share. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after 2-1
stock split. AAPL outstanding shares as of now is 937.41 million. If AAPL decides 2-1 split then the outstanding shares after the split would be 937.41*2 = 1,874.82 million shares.
A stock’s price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased. In the example of a 2-for-1 split, the share price will be halved. Thus, although the number of outstanding shares and the stock price change, the market capitalization remains constant. In case of AAPL, if AAPL is trading at $600 and you are holding 100 shares of AAPL, after the split you will have 200 shares of AAPL and ideally AAPL should be trading at $300. So on the date of split you will not see the affect of split in your portfolio just the increase in the number of shares. However, the research indicates a clear relationship between stock splits and outstanding stock price performance.
Most traders view stock splits as high potential trading opportunities. They consider splits positively and it brings goodwill for the company and the investors. Corporate executives use stock splits as marketing and investor relation tools. They know that stock splits make shareholders feel better and give them a sense of greater wealth.
Research indicates that stocks which are split perform 8% better during next three years than the companies which do not split. Some companies even reach their pre-split price in a matter of eighteen (18) months thus giving the investors an abnormal return on their investments.
Since the price of stock is reduced after the split it attracts many smaller investors. Companies report higher earnings and increase in dividends payout which attract more investors.
In summary, when you take into consideration of stock split, dividend payments, and possible inclusion of AAPL either in DJIA or S&P it is no wonder that AAPL has been running up after it dropped on earnings announcement. If AAPL is included in DJIA lot of index funds will be forced to buy AAPL shares. This will drive AAPL prices even higher. And on top of this after the split it would not be a surprise to see AAPL running towards its pre-split price as AAPL is the most beloved company in the entire world and investors believe it will continue to deliver in the future despite Steve Jobs untimely death.