If you receive more of something, that asset usually increases in intrinsic value. If you have two $100 bills and someone gives you two additional $100 bills, you have $200 more dollars. The sum is greater than its parts.
But what if you were told that you were going to receive four $50 dollar bills in place of your two $100 bills? Would you still feel the same way? You have more total bills, but the intrinsic value has not increased. That, in a nutshell, is the concept of a stock split. It’s a common practice for companies for a few reasons. However, the value of stock splits is one that analysts generally view as not having much shareholder value.
This article will define stock splits, why companies issue them, and whether or not they have shareholder value. This article will also explain the idea of a reverse stock split and the effect of a stock split on investors looking to short sell a stock.
What is a stock split?
A stock split is an action taken by a corporation through which they increase the number of their outstanding shares by dividing (or splitting) each share. This action will decrease the price of each new share by the same factor as the split. This is done so that the company’s market capitalization will remain the same as before the stock split.
For investors, a stock split is a sort of like asking somebody to give you change for a $20 bill. You wind up with more bills in your wallet, but the intrinsic value of those bills is the same. In the same way, you may wake up one morning to find that the number of shares of XYZ company has doubled, but the value of those shares remains the same (apart from normal market movement).
The net effect of a stock split for investors is that they receive an additional share(s) for every share they own, but the value of each share is now reduced by the factor of the split. If a company issued a 2:1 split, the value of each share would be cut in half. In a 3:1 split, each share would be cut by 2/3, and so on.
The most common splits are 2:1, 3:2, or 3:1. Let’s look at those splits from the point of view of the company and the investor.
First, let's look at stock splits from the company's point of view. Let’s say XYZ company has 1,000,000 outstanding shares trading at $60 per share. Their market capitalization is $60 million dollars. If they issue a 2:1 stock split, they now have 2,000,000 outstanding shares that are trading at $30 per share. Their market capitalization stays at $60 million dollars (2,000,000 x 30). In a 3:1 split, the outstanding shares would increase to 3,000,000 while the price per share would be reduced to $20 keeping the market cap the same. In a 3:2 split, the number of shares would increase to 1,500,000 and the price per share would become $40. In all cases, the market capitalization does not change.
Now let’s look at the same example from the point-of-view of an investor. If you owned 200 shares in XYZ company that were trading at $60/share and the company issues a 2:1 stock split, you now have 400 shares (200 x 2), but each share is now worth $30/share. So the net value of your holdings is the same $12,000. If the company offered a 3:1 split, you would now own 600 shares (200 x 3), but each share would now be worth $20/share. And, in a 3:2 split, you would own 300 shares at a price per share of $40. Again, the intrinsic value of your holdings remains the same.
Why do companies issue stock splits?
If there’s no change in their market capitalization, why would a company issue a stock split? There are two primary reasons. The first reason, and probably the most common, is that the company believes its shares are overpriced. This is not the same as saying they believe the stock is overvalued. Remember, the market capitalization doesn’t change. But perhaps, the stock is trading at levels so far above other stocks in its sector that it has become less attractive to investors. By lowering the share price, the company can make it more attractive, and accessible to more investors.
A second reason that a company may choose to issue a stock split is to increase the liquidity of their stock. Liquidity is a measure of how quickly shares can be bought or sold in the market without causing the stock price to increase. For example, when a stock like Apple is priced at hundreds of dollars per share, there can be a very large bid/ask spread. The bid/ask spread is simply the maximum price a buyer will pay versus the minimum price a seller will accept. If the spreads are too large, the stock will have less liquidity. In this case, a stock split may help make it easier for investors to buy and sell a company’s stock.
Do stock splits actually work?
Financial professionals and economic professors generally say stock splits are meaningless because the intrinsic value of the company does not change. Therefore, for an investor, there is no value. In this sense it's like receiving two $10 bills for a $20 bill, you have the same amount of money but you have an additional dollar bill. Still, companies do issue stock splits. And there is circumstantial evidence that concludes there can be a halo effect on stocks that split. The reason for this is psychological. When a stock splits, it can be viewed as a sign that there is interest in the stock. After all, the company is lowering their share price to make it more accessible to investors. There have been several examples of stocks that increase in value in the days and weeks following the initial drop following the split.
One of the best examples of this happened in 2014 after Apple issued a 7:1 stock split. Before the split, Apple’s stock was trading at a price of $645.57 per share. So after the split, the price was 645.57/7 = $92.70 per share. Apple’s outstanding shares increased from 861 million shares to 6 billion shares while its market cap stayed around $556 billion. Shareholders who owned 1,000 shares would now own 7,000 shares.
However, the day after the stock split, there was renewed demand from investors and the stock increased from $92.70 to $95.05 per share. So an investor who owned 7,000 shares on the day of the split would have seen a gain of $16,450. So it is possible, but it is not a reliable trading strategy.
What is a Reverse stock split?
If one of the reasons that a stock split is issued is to lower a stock's price per share when a company perceives their stock to be overpriced, then the simplest definition of a reverse stock split is a company action which results in a company's stock price rising.
In a reverse stock split, the number of outstanding shares decreases and the price per share increases. The practical example is you giving somebody two $10 bills in exchange for a $20 bill. Like a stock split let’s look at a reverse stock split from the point-of-view of a company and an investor.
Company ABC has 8 million outstanding shares valued at $2.50 share. Their market capitalization is 20 million dollars. They issue a 1:2 split. This decreases their outstanding shares from 8 million to 4 million and increases the value of those shares to $5.00. The market capitalization remains at 20 million dollars.
For an investor who owned 500 shares at $2.50. They would now own 250 shares at $5.00 per share. But the intrinsic value of that asset in their portfolio would still be $1,250.
So why do company’s engage in reverse stock splits? One practical reason is to maintain a listing on a major stock exchange. Many stock exchanges will delist a stock if its price per share falls below a certain amount. A second reason is if the company perceives that their stock is being manipulated as a result of speculator trading, a reverse stock split can help to reduce liquidity and therefore make the stock less tempting and less volatile. A final reason is more psychological and that is that their stock is trading far below other companies in their sector. In this case, a reverse stock split may make investors perceive their stock as being on par with others.
The effect of stock splits on short sellers
When an investor is trying to short sell a stock, they are borrowing shares of a company and are required to return them at a future date. Investors short sell a stock in anticipation that the price will fall. So a stock split may impact a short seller because the price moves down faster than they were anticipating. However, from an intrinsic value standpoint, it has no effect.
For example, if a short seller borrows 100 shares of a company’s stock that is trading at $30 per share and the company issues a 2:1 stock split, the investor will now have to return 200 shares but the cost per share will only be $15. A short seller can profit from a short sale if the price per share of the stock was higher when they initiated the trade, then when the stock split.
In our example, if the short seller bought the initial 100 shares for $35 per share, their initial investment as $3,500. If they decide to close their position immediately after the short sale, they would be required to buy 200 shares at the market price of $15 per share at a cost of $3,000. Their profit would be the difference between the entry price and the price they paid at closing. In this case, $500.
The final word on stock splits
Stock splits are common if a somewhat meaningless corporate action that effectively increases the number of outstanding shares while lowering the price per share by the same factor. Companies engage in this practice to make their share price more attractive to investors and to increase the liquidity of their stock in the market. The most common types of stock splits are 2:1, 3:2, and 3:1 although there are some stock splits that can be as high as 4:1, 7:1 or higher. There can also be more complicated splits like 1.3:1. No matter the type of stock split they all work the same way.
Analysts say that, because the intrinsic value of the stock does not change, nor does the company’s market capitalization, the stock split is a fairly insignificant action. However, there is a recognized halo effect that can happen to a stock immediately after a stock split. In this case, a company’s stock may rise after a stock split because investors perceive that the company is more attractive.
In a reverse stock split, the net effect is exactly the opposite of a stock split. The number of outstanding shares decreases while the price per share increases by the same factor. Reverse stock splits are typically done to discourage investor speculation and to prevent a company’s stock from being delisted on a major stock exchange.