A stock split is an adjustment in the total number of available shares in a publicly traded company. The price is adjusted such that the before and after market capitalization of the company remains the same and dilution does not occur. For example, if an investor had 1,000 shares of a company's stock that was priced at $100.00 and it went through a 2-1 split, the investor would have 2,000 shares at $50.00 per share after the split. What is a stock split?
A stock split is an adjustment in the total number of available shares in a publicly-traded company. As the number of available stock changes, the market capitalization of the company remains the same and dilution does not occur. For example, if an investor had 1,000 shares of a company's stock priced at $100.00 and it went through a 2-1 split, the shareholder would have 2,000 shares at $50.00 per share after the split.
Understanding Stock Splits and Why They Matter
What if you were told that you were going to receive four $50 dollar bills in place of your two $100 bills? The value of your money has not changed. You have more bills now, but the intrinsic value has not increased. This, in a nutshell, is the concept of a stock split. A company may make the decision to issue a stock split or reverse for a variety of reasons. How do stock splits impact investors? Read on to find out more.
What Does It Mean When a Stock Splits?
A stock split is a decision that a publicly-traded company makes to adjust the total number of shares that the company has issued. The outstanding shares of stock are adjusted by dividing or multiplying each share by a predetermined amount. Stock splits are corporate actions that 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.
Market capitalization is the total value derived from the number of outstanding shares and the price per share. For an invested shareholder, a stock split is like somebody taking $20 out of your pocket and putting four $5 bills back. 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 a given 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 stock split ratio with a 2:1 split, the value of each share would be cut in half. In a 3:1 stock split ratio, each share would be cut by 2/3, and so on. Common splits include a 2:1, 3:2, or 3:1 split. Stock splits can also impact the cash dividend per share. Dividends are profits that a company passes to shareholders at a pre-defined rate on specified dates throughout the year. In contrast, growth companies tend to keep the profit rather than issue a dividend payout and use the retained earnings to encourage growth.
Reasons for a Stock Split
If there’s no change in its market capitalization, why would a company issue a stock split? There are several reasons. 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 and increasing available shares, the company can make it more attractive and accessible to improve investor relations. A company may also choose to issue a reverse split to soak up outstanding shares and increase the price per share. Both methods can be used to keep a share price within a certain range to encourage specific investor participation at various stages of the business life cycle. Stock splits also tend not to drastically impact each shareholder of record.
Another reason that a company may choose to issue a stock split is to increase the liquidity of its stock. Liquidity is a measure of how quickly shares can be bought or sold in the market without causing the stock price to increase significantly. This is reflected by what traders of stock certificates are willing to pay for shares of stock since cash is the standard of liquidity. 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. As the stock becomes more available and easier to trade, it becomes more liquid—but also more volatile. Trading the most volatile stocks can be profitable if handled correctly.
How a Stock Split Works
Stock splits or stock reverse splits occur when a company owner or board of directors decides to issue one. First, let's look at stock splits from the company's point of view. Let’s say a company has 1,000,000 outstanding shares of common stock 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. In every case, the company now has more shares outstanding that can be traded on exchanges.
Now, let’s look at the same example from the point of view of an investor, brokerage account manager, or other account director trading securities on a stock exchange (like the New York Stock Exchange). If you owned 200 shares in that same company that was trading shares worth $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. However, the impact of the stock split can show up in other ways. The increased supply at a lower price may drive investing demand which could increase the value of the stock temporarily. Some investors choose stocks that are projected to grow rapidly, such as these stock market gainers. There are a variety of factors involved, but the increased liquidity of shares after a stock split can increase the volatility and corresponding risk of the stock.
Example of a Stock Split
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. 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 its 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. 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. While such returns are possible, it is not a reliable trading strategy because it is difficult to predict both the occurrence of stock splits and the impact on investors.
Other trading strategies include dividend investing and growth investing. Growth stocks are those issued by companies that are focused on activities that will increase the share price over time. Check out these best growth stocks for more information.
Upcoming Stock Splits
There are several reasons to keep an eye on upcoming stock splits. Depending on many factors, these may make good investments for some. On the other hand, a stock split may get in the way of other investing strategies, such as short-selling. 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.
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 because the total value the investor borrowed is the same as before. For example, if a short seller borrows 100 shares of a company’s common stock that is trading at $30 per share and the company issues a stock split ratio of 2:1, 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, compared to 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: $500. But what happens if the price increases following the split and before you buy? Your cost basis in the original issued shares could be higher than your expected return. There are also accounting issues that arise when issues stock splits, which may result in extra fees for some accounts.
What Is a Reverse Stock Split?
In a reverse stock split, the number of outstanding shares decreases and the price per share increases. A practical example is giving somebody a $20 dollar bill for their two $10 bills. Let’s look at a reverse stock split from the point of view of a company and an investor. Company A has 8 million outstanding shares valued at $2.50 share. Their market capitalization is 20 million dollars. They issue a 1:2 reverse 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 companies engage in reverse stock splits? One practical reason is to maintain a listing on a major stock exchange. Cheap stocks, like penny stocks, offer a different type of investing strategy for investors. Some stock exchanges will delist a stock if its price per share falls below a specified 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 other similar companies.
Why Does a Stock Split Matter?
Stock splits are a corporate practice that effectively increases or decreases the number of outstanding shares while lowering or raising the price per share by a specified 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 even higher. Because the intrinsic value of the stock does not change, nor does the company’s market capitalization, the stock split is not normally a point of concern for most investors.
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. Some of the risks associated with stock markets and exchanges have been mitigated by organizations, such as the Securities and Exchange Commission.
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. To avoid being surprised by any changes to your portfolio of stocks you may want to track or receive alerts when stock splits are scheduled.
