A spinoff is when a company takes a portion of its operations and breaks it off into a separate entity. In a spinoff, shares of the new company are distributed tax-free to shareholders of the parent company. Companies spin off portions of their operations for several reasons. When a company has a profitable division that isn't exactly related to its core competencies, it may decide that putting that division under separate ownership and separate management enables both parent company and subsidiary to focus on what they do best. Another common reason for spinoffs is when a large company with many separate divisions has a stock price that management feels understates the value of those divisions put together. By spinning off one or more of those divisions, management hopes the combined stock value eventually surpasses what it was as one consolidated unit.
When a spinoff happens, investors in the parent company automatically become investors in the subsidiary through the tax-free distribution of new shares. New investors can purchase shares of one or both companies.
Either type of investor should be aware of a few things that typically happen to stock prices after a spinoff. It is common for the stock price of the parent company to take an immediate dip. Assets that now belong to the subsidiary were removed from the parent company's books, which lowers its book value. However, the value of the subsidiary's shares tend to make up the difference; the sum of the two stock prices typically approximates the parent company's pre-spinoff stock price.
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 spinoff. Investors who have been able to withstand the unpredictability of the initial days and weeks have seen nice gains. New investors looking to take advantage of a spinoff's historical benefits must choose between investing 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. However, compared to the more established parent company, the subsidiary's stock price is more volatile and subject to market whims. Even though spun-off companies generally do well in the long term, the early bumps in the road with which any new company must contend are enough to scare off some investors.
Those looking for 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, and 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.