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What Do Corporate Spinoffs Mean for Investors?

What Do Corporate Spinoffs Mean for Investors?

This is part 2 of a two-part series on spin-offs. Read part 1 here.

When a company engages in a spinoff, it does so in anticipation of certain benefits, such as adopting a sharper business focus that could lead to higher profits down the road. But when a company engages in a spinoff, it isn’t just the number of companies that multiplies. The number of ticker symbols in an investor’s portfolio will multiply as well.

In a spinoff, a parent company typically distributes shares in the new company to parent company shareholders on a pro rata basis — that is, the number of shares an investor holds in the parent company determines the number of shares he or she will receive in the new company. Once the new company begins trading, the parent company's share price is adjusted to reflect the fact that its valuation no longer includes the spun-off unit.

For instance, in online auction giant eBay Inc.’s spinoff of its online payment subsidiary PayPal Holdings Inc., eBay shareholders received one PayPal share for every share of eBay stock owned.

The day before PayPal began trading on the open market, shares of eBay closed at $66.29 a share. The next day, PayPal’s shares closed at $40.47 a share after the first day of open-market trading, while eBay shares immediately dipped to close at $26.59 a share the same day, giving the shares a combined value of about $67.06, just 1.2 percent more than the value of eBay shares the day before.

And spinoffs can impact share prices even before the deal is executed. When a spinoff is first announced, if many believe the expected transaction will reap rewards for the parent company or create a successful new company, the parent company's share price may rise.

If investors have their doubts about the wisdom of a spinoff, however, the parent company's share price may fall. In 2002, the conglomerate Tyco International PLC infamously cancelled plans to divide itself into four companies after its shares plummeted following the initial break-up announcement.

In the months following a spinoff, shareholder gains are no guarantee, but one study found that often, the price for both the parent and spun off entity do increase.

One year after a spinoff, parent companies, on average, saw share price gains of 14 percent, according to analysis by investment research firm The Edge and Deloitte that looked at hundreds of spinoff transactions from 2000 through 2014. Meanwhile, the spun-off companies saw greater returns, climbing on average of 22 percent in value after their first year in business, according to the The Edge and Deloitte report.

But still, a significant number of spun off business don’t fare so well. The Edge and Deloitte analysis found that 40 percent of spun off companies didn’t generate any stock returns in their first year. Parent companies, meanwhile, aren't guaranteed to see share price increase, either. The market could ultimately decide that the spinoff hurt the parent company, or its share prices could drop for reasons unrelated to the spinoff.

Given that, once a spinoff occurs, investors have an important decision to make: whether to sell or hold shares of the parent company and whether to sell or hold shares in the new company. What they decide may hinge on their risk profiles.

For instance, if the new company is fast-growing, but volatile, while the parent company features stable, but low returns, a risk-averse investor may choose to hold shares of the parent company while selling those of the new company.

"Spinoffs allow you to allocate your money in whatever way you see as being best suited to your demands," said Emilie R. Feldman, an associate professor of management at the University of Pennsylvania's Wharton School.

As with any investment decision, it's critical to do your research when determining how to manage your portfolio following a spinoff or a spinoff announcement. Important information about corporate spinoffs, such as the company’s rationale behind the spinoff and the new company's strengths and strategy, can often be found in a type of Securities and Exchange Commission filing known as Form 10-12B, which is typically required of companies that are issuing new shares as part of a spinoff. A company may also file a Form 8-K with details about a proposed spinoff or a spinoff under consideration.

SEC filings are available to the public through the Commission's EDGAR database.

For more about why a company may decide to go down the path of a spinoff, read this.