How to Make Money On a Stock Spinoff

A stock spin off can provide a unique investment opportunity for investors. Studies have shown that the shares of these stocks tend to out perform the market by a wide margin. An understanding of stock spin offs and why they occur can give some clues and insights into why these stocks perform so well. These stocks often provide opportunities many investors overlook.

What are Stock Spin offs?

A stock spin off occurs when a parent company separates a division, or business unit, into a separate individual company. The new company becomes a totally independent entity. Therefore, the new company has its own management team and operations. The financial results of the two are reported separately. In addition, the newly formed company has its own stock. This means that the price of shares of the parent company will usually reflect the change. Therefore, the shareholders of the original company usually receive shares in the new company. Typically, this is done according to a formula. For example, a shareholder might receive one share in the new company for every five shares they currently own in the original parent company. Often there is a provision to pay shareholders in cash for fractional shares resulting from the formula.

Reasons for Stock Spin Offs

There are generally three primary reasons for a stock spin off. First, it may occur when a company wants to maximize the investment opportunities of a high performing unit, or division. In some cases, the performance can be buried inside the large conglomerate. When the financial results are reported separately it highlights the outstanding performance. Therefore, the unit is allowed to reach it's full potential.

The second reason can be just the opposite of the first. The parent company may desire to be separated from a poor performing unit. One unit may have an adverse impact on the entire company. Therefore, the spin off of the poor unit may highlight the performance of the better performing units of the parent company.

The third reason is unrelated to actual performance. Management may determine that a particular line of business is not compatible with the products, services or future direction of the company. Therefore, the decision is primarily based on a company's vision or strategy.

Making Money on a Stock Spin off

A stock spin off can provide an unique opportunity for investors. The new companies are often more efficient and creative and can reach their full potential easier. Many times, the market does not have the capability of measuring these advantages. In the absence of concrete data, the tendency in market is to err on the side of caution.  Therefore, it is not uncommon for spin offs to be undervalued initially. Over time, the market will adjust and these stocks will rise to the true market value. However, there is a window of opportunity for investors to identify undervalued spin offs. Investors who are willing to spend the time and effort to research spin offs are likely to find many potential bargains.