How Do Spinoffs Impact Investors in Parent and Subsidiary Companies?

A spinoff is created when a company forms some part of its operations into a separate entity and distributes shares in it tax free to shareholders of the parent company. The number of shares that a parent company shareholder receives is based on the number they own in the parent company.

When a spinoff's shares start trading on a stock exchange, the value of the parent company's stock may drop by the value of the new company's stock. This is due to the fact that the parent company stock no longer reflects the value of the unit that was spun off. Parent company shareholders shouldn't be concerned by this price change because they own the spinoff's shares as well.

The spinoff will get a new name and a new management (unless it had an experienced management in place prior to the spinoff). Spinoffs have generally performed successfully over time.

Key Takeaways

  • A spinoff is created when a company forms some part of its operations into a new entity and issues stock in it to parent company shareholders.
  • The number of shares received depends on the number of shares an investor holds in the parent company.
  • Spinoffs can have great potential for growth due to their smaller size and a management motivated to achieve success.
  • Due to stock price volatility, spinoffs can underperform in weak markets and outperform in strong markets.
  • Historically, spinoffs have been good investments for investors.

Reasons for Spinoffs

Companies create a spinoff for several reasons, all of them grounded in added financial return for the parent company.

For one, a company may create a spinoff because, as part of the company, a division didn't fit well with its core competencies. As an independent company, the spinoff may focus more effectively on its own operations and flourish. The parent company then can better utilize its own resources for future successes, as well.

If a company has sought, but failed to interest, a buyer in purchasing a division, it may decide that a spinoff is its next best option. As a spinoff, the newly restructured division may exceed its past performance when part of the parent company and boost financial gains.

A company may be so large that it's unable to effectively and efficiently manage a division so that it achieves value. In such a case, a spinoff can help by allowing the parent company to put its efforts to better financial use.

Another common reason for spinoffs is to improve stock value. For example, a large company with many divisions may have a stock price that management feels understates the value of those divisions. In spinning off one or more of them, the expectation is that the new companies will perform successfully. As a result, their individual stock values would eventually surpass the value they had when part of the parent company.

Impact on Investors

Shareholders should be aware of the price dip that typically happens to the parent company stock price after a spinoff. This occurs because assets that now belong to the subsidiary are removed from the parent company's books, which lowers the parent company's book value.

However, the value of the subsidiary's stock tends to make up the difference that this dip causes. The sum of the two stock prices typically approximates the parent company's pre-spinoff stock price.

Spinoffs shares can lose value for a period of time after the new company is created for other reasons, as well. The drop can be due to parent company shareholders selling their spinoff shares. Some institutional shareholders such as index funds may sell shares because a spinoff isn't part of the benchmark they follow. Other institutions may sell because the spinoff doesn't meet their investment criteria.

The share price of the parent company can rise when spinoff plans are announced if investors believe such a move is financially beneficial. Of course, they could also decide a spinoff isn't wise and sell shares in response to the news. Depending on their point of view, such a time could offer existing shareholders the opportunity to buy or sell parent company shares.

Spinoff investors may see share price volatility due to the company's newness and lack of financial results. As a result, spinoff stock can underperform when markets are weak and outperform when markets are strong.

Spinoffs can perform well due to the force of an enthusiastic management that's eager for success and potentially motivated by financial incentives. What's more, with a parent company now free to focus fully on its own operations, the value of both entities' stock can rise.

Generally speaking, after early price drops, spinoff stocks strengthen and offer a positive performance for several years. They tend to outperform over time. This bodes well for investors who prefer to hold on to their shares.

Make money with spinoffs

The volatile price action of a smaller, fast-growing spinoff's stock can mean the potential for lost value. Shareholders who prefer stability could choose to take profits by selling spinoff shares in an uptrend and continue to hold their company shares.

Are Spinoffs Good for Investors?

Historically, spinoffs have been good for investors. On average, both the parent company and the subsidiary outperform the market during the 24-month period following a spin off. Investors who have been able to withstand the unpredictability of the initial days and weeks may see nice gains. New investors looking to take advantage of a spinoff's benefits can choose to invest in the parent, the subsidiary, or both.

Aggressive investors with a high tolerance for risk are often drawn to the subsidiary. As a smaller company, the subsidiary has more potential for growth. Its now singular focus on its own core operations can lead to profitability and a higher stock price. Its wide open future can attract investors, boosting share price.

Investors who prefer more stable returns tend to stick with the parent company. Most companies that are large and established enough to spin off a division have low volatility. Their stock prices remain stable even when the market oscillates wildly. During uncertain economic times, risk-averse investors look to the parent company after a spinoff for better-than-average returns without excessive risk.

Notably, spinoffs can present investors with challenges as well as opportunities. As mentioned, compared to the more established parent company, the subsidiary's stock price is more volatile and subject to market whims.

It's also possible that a spinoff could be loaded with debt and troubled assets. This could put it at a disadvantage and make it an investment to avoid.

What's more, the new company may need support from the parent. Employees with job insecurity could affect a spinoff's performance.

Not all spinoffs generate shareholder value in early years. In fact, the early bumps in the road with which any new company must contend are enough to scare off some investors. Nevertheless, spinoffs generally do well in the long term.

Why Do Investors Like Spinoffs?

Some investors, especially those with higher risk profiles, are attracted to spinoffs for the growth opportunities that the new, smaller companies offer. Spinoffs typically have a management that's motivated to succeed. The focus on operations, sales, and revenue can be given full rein since leaving the parent company. Historically, spinoffs have performed well over the long-term.

Are Spinoffs Good for Investors?

They can be. As a new, smaller company, a spinoff can offer investors attractive potential for growth in share price as it produces solid financial results. Bear in mind that spinoff stock prices tend to be more volatile. While spinoffs can outperform in an upward trend they can underperform in a weak market. Ultimately, investors should thoroughly research a spinoff to decide whether to invest or not.

Do Spinoffs Create Value?

Yes, but not necessarily in their early years. As with any company, value is created as revenue is generated, profits are captured, and business success is achieved. It helps when a spinoff's management has a financial stake in the company through stock options or substantial equity positions. As a result, investors could see their spinoff stock rise in value.

The Bottom Line

Spinoffs can impact investors in different ways. Spinoff shares can be volatile in the early period after a new company is created. Yet, a spinoff is often helmed by enthusiastic officers and managers who are motivated to see the value of their company and its stock emerge and grow.

Aggressive investors with a higher tolerance for risk may prefer holding shares of spinoff stock. More risk-averse investors may instead choose the stability of parent company stock.

Ultimately, spinoffs tend to perform well over time. However, investors interested in buying stock in a spinoff should thoroughly research its financial and business information before taking a position.