Research by Fredonia Business professors confirms ‘signaling hypothesis’ of stock splits

The research project “Stock Splits and Cash Flows: A New Test of the Signaling Hypothesis,” initiated in 2015 by Drs. Taihyeup Yi and Julie Fitzpatrick of the School of Business, confirmed that the stock market reacts positively to announcements of stock splits, even though these splits have no net effect on a shareholder’s wealth.

A stock split occurs when a company issues additional shares of stock to its current stockholders.

For example, the research duo explained, in 2014 Apple split its stock 7 for 1 when the stock price was $645 per share. After the split, Apple’s stock price was 1/7 of $645, or about $92 per share. As a result, a shareholder who previously owned 100 shares at a price of $645 would own 700 shares at a price of about $92. Therefore, the stock split had no net effect on the shareholder’s wealth since he/she owns more shares but each share is worth less.

Although stock splits should, in theory, have no effect on shareholder wealth, prior research nevertheless found that the stock market reacts positively to announcements of stock splits.

The signaling theory offers one explanation why the stock market reacts positively to a stock split. A firm’s managers are assumed to have access to more detailed information than investors about the firm’s future prospects, thus a stock split reveals the manager’s favorable information about the firm’s future prospects.

As a result, firms that undertake stock splits may have better future performance. The cash flows of splitting firms was used by Yi and Fitzpatrick in their analysis of the theory. They developed a signaling model to examine whether a firm’s split factor contains privileged information regarding the firm’s future prospects. They found that a firm’s chosen split factor conveys a manager’s private information of unexpected future profitability, thereby supporting the signaling hypothesis of stock splits.