In the vast and complex world of finance, there are countless terms and concepts that can make even the bravest investor’s head spin. One such term is “tracking stock.” Don’t worry if you’ve never heard of it before; by the end of this article, you’ll be an expert on how tracking stocks work.
What is a Tracking Stock?
Imagine you own a big company that has several different divisions, each with its own unique products and markets. Managing all these divisions can be quite a handful, especially when it comes to tracking their financial performance. This is where tracking stocks come in.
A tracking stock is a type of stock that is specifically designed to track the financial performance of a particular division or business segment of a larger company. It allows investors to buy and sell shares based on the performance of that specific division, rather than the entire company.
Think of it like this: Imagine you have a large fruit farm with apple, banana, and orange orchards. Each orchard has its own production, sales, and profits. A tracking stock would allow investors to invest in just the apple orchard, for example, without having to buy shares of the entire fruit farm.
How Do Tracking Stocks Work?
Tracking stocks work by creating a separate class of shares for a specific business segment. These shares trade independently of the parent company’s main stock, reflecting the financial performance of that particular segment.
Here’s a step-by-step breakdown of how tracking stocks work:
Identify the Business Segment: The first step is to identify the specific business segment or division that you want to track. This could be based on various factors, such as product line, market, or geographical location.
Create a Separate Class of Shares: Once the business segment is identified, the parent company creates a new class of shares specifically for that segment. These shares are usually listed on a stock exchange and trade independently of the parent company’s main stock.
Determine the Valuation: The valuation of the tracking stock is usually based on the financial performance of the specific business segment. This includes factors like revenue, profits, and growth potential.
Trading: Investors can buy and sell these tracking shares on the stock exchange just like any other stock. The price of the tracking stock fluctuates based on the performance of the business segment it represents.
Dividends and Other Benefits: Depending on the performance of the business segment, the tracking stock may also offer dividends or other benefits to its shareholders.
Pros and Cons of Tracking Stocks
Like any financial instrument, tracking stocks have their own set of pros and cons.
Pros:
Focused Investment: Tracking stocks allow investors to focus on a specific business segment, rather than the entire company. This can be particularly useful for investors who are interested in a particular product line or market.
Increased Transparency: By tracking the performance of a specific business segment, tracking stocks provide greater transparency into the operations and financials of that segment.
Potential for Higher Returns: If the specific business segment performs well, the tracking stock may offer higher returns than the parent company’s main stock.
Cons:
Complexity: Tracking stocks can be complex to understand, especially for investors who are not familiar with the underlying business structure of the parent company.
Volatility: The price of tracking stocks can be more volatile than the parent company’s main stock, as they are more closely tied to the performance of a specific business segment.
Corporate Actions: Corporate actions such as mergers, acquisitions, or spin-offs can affect the value of tracking stocks in unpredictable ways.
Real-Life Examples of Tracking Stocks
To better understand how tracking stocks work, let’s look at a few real-life examples.
Alphabet (GOOGL) and Google (GOOG):
Alphabet Inc. is the parent company of Google. In 2015, Alphabet was created to separate Google’s core business from its other investments and businesses. Alphabet’s main stock (GOOGL) tracks the performance of the entire company, while Google’s tracking stock (GOOG) specifically tracks the performance of Google’s core business.
GE (GE) and Baker Hughes (BKR):
General Electric Company (GE) once owned a majority stake in Baker Hughes, an oilfield services company. In 2017, GE spun off Baker Hughes as a separate company, but created a tracking stock (BKR) that allowed investors to continue to invest in Baker Hughes within the GE family of stocks.
Disney (DIS) and ESPN (Tracking Stock Concept, Not Actual):
Although ESPN is not currently a tracking stock, it was once rumored that The Walt Disney Company (DIS) might create a tracking stock for its ESPN division. This would have allowed investors to invest specifically in ESPN, rather than the entire Disney company.
Should You Invest in Tracking Stocks?
Whether or not you should invest in tracking stocks depends on your investment goals and risk tolerance. Tracking stocks can offer a focused investment opportunity in a specific business segment, but they also come with increased complexity and volatility.
Before investing in tracking stocks, it’s important to do your research and understand the underlying business structure of the parent company. You should also consider your investment goals and whether a tracking stock aligns with those goals.
As with any investment, it’s always a good idea to diversify your portfolio and not put all your eggs in one basket. Tracking stocks can be a valuable addition to your portfolio, but they should be just one part of a larger, diversified investment strategy.
Conclusion
Tracking stocks can be a useful tool for investors who want to focus on a specific business segment of a larger company. By creating a separate class of shares for a particular division or business segment, tracking stocks allow investors to buy and sell shares based on the performance of that segment, rather than the entire company.
While tracking stocks offer increased transparency and potential for higher returns, they also come with increased complexity and volatility. Before investing in tracking stocks, it’s important to do your research and understand the underlying business structure of the parent company.
Remember, tracking stocks are just one part of a larger, diversified investment strategy. By understanding how they work and considering your investment goals, you can make informed decisions about whether or not to invest in tracking stocks.
So, there you have it—a comprehensive guide to how tracking stocks work. Now you can impress your friends and family with your newfound knowledge of this fascinating financial instrument. Happy investing!
Related Topics:
