Stub: What it is, How it Works, Examples

What Is a Stub?

In finance, a stub is a security that is created as a result of a corporate restructuring such as a spin-off, bankruptcy, or recapitalization in which a portion of a company's equity is separated from the parent company's stock. Stub stocks may also be created by converting a distressed company's bonds into equity.

The term stub may alternatively be used to refer to the balance part of a check, such as a paystub or from a receipt that is retained for record-keeping and audit trail purposes or as proof of payment.

Understanding Stubs

Stubs are commonly created through a spin-off. In a spin-off, the parent company distributes shares of the subsidiary that is being spun-off to its existing shareholders on a pro-rata basis, often in the form of a special dividend. The company that is spun-off is a distinct entity from the parent company and has its own management and board of directors. The parent company may spin off 100% of the shares in its subsidiary, or it may spin off 80% to its shareholders and hold a minority interest of less than 20% in the subsidiary. In a stub, the parent spins off most of the subsidiary. Because the parent company's stock may retain most of the attractive characteristics of the original investment, stub stocks are not typically viewed as desirable by investors.

Stubs may also arise from a corporate restructuring, such as when emerging from bankruptcy. Stub stock values typically represent only a small fraction of the price of the parent securities from which they have been created. Their lower prices can reflect the uncertainty that market participants perceive regarding the recapitalized company's prospects. That uncertainty makes stub stocks often speculative investments with significant positive return potential should the company's managers succeed in turning the firm around, but also greater risk. For example, investment firm Salomon Brothers had created an index of stub stocks in the 1980s. The index's value had steep swings in relation to the market's performance. In 1987, it crashed by 47.4% during that year's bear market. The S&P 500 fell by a more modest 33% in the same period.

To value stubs, analysts focus on the amount of their debt and capital available at the company to service the debt. The cash flow ratio becomes an important measure in this analysis because it provides a look into the amount of cash that the company has at its disposal to service debt. The price-to-earnings (P/E) ratio, an important metric for valuation in traditional analysis, is not as important because profits for stub companies are generally not high.

Example of a Stub: 3Com and Palm

Networking company 3Com, which manufactured the successful Palm Pilot device series in the 1990s, spun out 7% of its Palm subsidiary in 2000. 3Com still owned 95% of the new company after the separation and received a $200 million special dividend and tax rebates from the spin-off.

Palm also offered a limited number of shares to the public in 2000. Investors unable to get in on the action of the offering loaded up on 3Com's shares, driving up its valuation from $5 billion to $22 billion in a matter of months. Palm surged even higher, thanks to the dotcom mania around computing products. It had a closing price of $95 at the end of its first day of trading and a market capitalization of $54 billion, higher than that of its parent. It was even higher than that of established names like General Motors, Chevron, and McDonald's.

With the introduction of new portable computers and smartphones, the market for Palm's products dwindled. Eventually, the company was bought by Hewlett Packard in 2010, and its flagship product, the Palm Pilot, was discontinued in 2011.