In a spinoff, a company segregates certain assets into a separate entity and spins off, or distributes, shares in that entity to the current shareholders, typically in a tax-free transaction. Different spinoffs affect parent companies’ stock prices in different ways.
The most typical reason for a spinoff is that the stock price of a large diversified company does not fully reflect the value of all its diverse components, so the management feels that it can enhance shareholder value by spinning off certain assets into a separate company. Another reason may be that a parent company has built a valuable fast-growing subsidiary whose business differs from the main business of the parent company, so the management feels that it is best for the new subsidiary to function as an independent entity. Whatever the reason, the underlying math is essentially the same: the parts should be worth more than the whole.
Stock Price on the Day of Spinoff
On the day of the spinoff, the stock price of the parent company typically drops to reflect the fact that certain assets have been removed from its books and segregated into a new separate entity. Once a spinoff starts trading, the prices of the parent company’s and spinoff’s stocks should add up to the price of the old parent company stock prior to the spinoff, at least initially. Eventually the prices of the two new companies will be set by the market based on their individual values and prospects.
A parent company may spin off the entire subsidiary or distribute only a small percentage of shares and retain a stake for possible sale later. In a complete spinoff, the parent company’s stock starts trading on its own merit -- that is, on the growth prospects of the remaining business; in a partial spinoff, the parent company’s stock price should reflect the value of that subsidiary’s stock holding.
ABC is a large established company with many diverse businesses but stagnant growth. Its current stock price is at $48. With 1 billion shares outstanding, ABC’s current market cap (current stock price multiplied by shares outstanding) is $48 billion, but its book value (balance of assets and liabilities) is $60 billion, so the management feels that ABC stock is undervalued. ABC has a fast-growing subsidiary that it decides to spin off into a separate company -- XYZ. XYZ is created with 100 million shares outstanding. ABC spins off 20 percent of the shares -- 20 million -- to the existing shareholders by segregating $6 billion in assets into the new entity, and retains an 80 percent stake. XYZ’s $6 billion book value suggests a stock price of $60 per share ($6 billion divided by 100 million shares). After the spinoff, ABC stock drops to $42 per share to reflect the $6 billion drop in its book value. In the meantime, excited about its growth prospects, XYZ investors quickly bid up its share price to $200. XYZ’s market cap is now $20 billion. ABC’s 80 percent stake in XYZ is worth $16 billion (it lost $6 billion million in assets but gained $10 billion in the market value of the spinoff) so its stock begins to trade at around $58 per share to reflect the new valuations.