A stock split is when a company issues new shares to its existing shareholders, but also reduces the price by the same ratio so that the value remains unchanged.
Stock splits have become quite common in recent years. Many major companies such as Amazon, Apple, and Google have split their stock in the last few years. A stock split has both advantages and disadvantages, and there are multiple reasons why a company may consider a split.
Here, we take a look at how stock splits work, why companies may consider splitting their stock, and whether there are any true advantages to this. Let’s begin by taking a look at what a stock split is.
There are many factors that impact the price of a stock. These include company-specific information (information about the performance of the company), market-wide information (general outlook of the industry and the economy), and noise (random movements of the market).
Really successful companies may have stock prices get too high for a single share. In order to make their shares more accessible, the board of directors will decide to split the stock. Here, each owner of a share is handed out multiple new shares, but the value of the holding is not diluted.
Let’s suppose that there is a company that has its stock trading at $100 a share. The Board of Directors decide to do a 2-for-1 stock split. In this case, each owner of the share will receive an additional share. The value of the new shares will be $50 each.
If the company had decided to do a 4-for-1 stock split, each owner of the share would have received three additional shares. The value of the new shares will be $25 each.
Let’s take a look at some of the major companies that have split their stock.
Tesla has undergone multiple stock splits. We will be taking a look at the one that took place in August 2022.
The stock split had been rumored for months, and was finally announced on August 5. It was to be a 3-for-1 stock split, with the stock to begin trading at its share adjusted price on August 25.
On the day of the split, the stock closed at a lower price than it had opened. The total difference was roughly 2%, with the stock falling from $302 to $296.07. The day before the stock split, the stock at closed at a price of $891.29.
At the time of writing, the Apple stock has been split over five times. It has also generally tended to perform well in the year after it splits its stock.
The most recent stock split took place on 28 August 2020. This was a 4-for-1 split, and was done because the share price had reached an astronomically high amount after its recent bull run. The market capitalization of the company had crossed $2 Trillion at this point.
The stock was split after the market close on 28 August, with 31 August being the first day of trading. Apple’s stock rose by a small amount on the first day of trading after the stock split. It opened at $127.58 and closed at $129.04.
Amazon announced its first stock split in over 22 years in 2022. The stock was to be split on a 20-for-1 basis on June 6, 2022. The company also announced a $10 billion share buyback program.
The price of the stock was at $2,785 when the split was announced in March. The main reason for the split was to make the stock more liquid, something we discuss in detail later on.
The stock price rose by 5% on the announcement of the split. However, the stock underperformed on the first day of trading. The price opened at $125.25, got as high as $128.99 before falling and closing at $124.79.
Now that you know what is a stock split, let’s look at the reasons for a stock split. At its fundamental level, stock splits do not have any tangible benefit to the company. They do not change the performance of the company in any way, and all the research into the company will still be performed in a similar manner.
Here are the main reasons for stock split:
- Decreasing the price of the shares
- Making the stock more accessible
- Reduction in trading costs
- Versatility for shareholders
For the most part, a board may decide to split the stock in order to make it cheaper to buy. When the price of a stock becomes too high, it can be difficult for retail investors to purchase shares.
For example, Amazon was trading at over $2,500 before one of its splits. Not many investors have the capital to purchase a single share for that high an amount. As such, splitting the stock allowed Amazon to open up to a whole new class of investors.
Simply put, stock splits can allow the shares of a company to be more liquid. However, it is also important to remember that many companies do not wish to split their stock, seeing it as nothing more than a gimmick.
Warren Buffet, perhaps the most well-known and respected investor in history, has said that he will never split the Class A stock of his company. This is precise to avoid speculation by having retail investors continuously trade it. According to Buffett, keeping the price high will allow long-term investors looking for quality investments to invest in the company only. A single share of Berkshire trades in the hundreds of thousands of dollars, and its all-time high was over $500,000.
Now, let’s take a look at the pros and cons of stock splits.
Apart from the fact that stock splits can increase the liquidity of a company’s shares, there are a couple of other benefits to splitting the stock.
When a stock split is announced, there seems to be a positive impact on the price of the share. According to data from the Nasdaq Economic Research team, the average stock rises 2.5% from the date of the announcement to the date of the split.
Stock splits also tend to reduce the cost of trading a company’s share. If the price of a share is too high, the spread is also greater than on the average stock. As such, the split allows those that want to invest in the company to do so a bit more cheaply.
Due to the stock being cheaper after a split, there is usually a higher volume of trading after a split. A higher volume generally means lower spreads, which can make trading a bit more efficient.
Those who already had the stock prior to the split now have more options and more flexibility when it comes to asset allocation. For example, those that had a single share of Amazon prior to the 20-for-1 split would have 20 shares afterward. As such, they could decide to sell 5 and keep 15. This would not have been possible prior to the split.
Stock splits also have a few disadvantages, and this is something that both the directors of the companies and the investors need to be aware of.
This is a knock-on effect of the higher liquidity. Since there are a higher number of investors that could purchase the stock, there is a potential for there to be higher volatility as well.
We say potential because higher volatility is not always the case. However, volatility can be a huge factor during turbulent times for the company or during bear markets.
As stated previously, stock splits do not alter the performance of the company in any way. While there is data that suggests that share prices go up in the long run after a split, it is also important to remember that most stock splits happen during bull markets.
Once a stock split has taken place, it can be a bit difficult for accountants to keep track of all the changes that have occurred. On top of that, shareholders and analysts may face a similar predicament.
A stock split costs money. For one, the company will have to hire an investment bank that can update the records and perform the stock split. On top of that, there will also be legal requirements that the company will have to comply with.
While a stock split will not impact a large company’s financials in any significant manner, smaller companies might be better off saving that money.
A reverse stock split occurs when a company aims to boost the value of its shares. So, a reverse stock split would be something like 1-for-2 shares, where every owner will hand in two shares and receive a single one in reverse.
For the most part, the advantages and disadvantages of a reverse stock split are the complete opposite of a stock split. However, there is one reason why companies may consider a reverse stock split important.
Most stock exchanges have a limit below which a company’s stock ends up becoming delisted. If a company is performing poorly and is close to that figure, the directors may decide that it is safer to increase the price through a reverse stock split. So, a share that was trading at $3 would be trading for $6 after a 1-for-2 reverse split.
Overall, a stock split does not have a meaningful impact on any investor’s portfolio. The only significant change is in the number of shares owned by the investor.
However, everything else that has been mentioned above will impact the investor. If history is to go by, a stock split will lead to positive returns in the months after the split. However, it is important for investors to remember that past performance is not indicative of future results. As such, investing in a company only because its stock is about to split is probably not a good strategy.
Stock splits allow a company to increase the total number of shares it has outstanding. The overall value of the company stays the same during a split. Usually, stock splits have both advantages and disadvantages. The primary advantage is the introduction of the stocks to a new class of investors, while the primary disadvantages include costs and potentially higher volatility.
A company will usually decide to split stock if its share price gets too high. With the increase in the number of shares, each share is then worth a smaller amount.
On the other hand, a company may decide to do a reverse stock split if the share price is too low.
Google has split its stock three times. The first was in 2014, the second in 2015, and the final one in 2022.
Amazon has split it’s stock a total of four times, each time because its price was a bit too high. The most recent Amazon stock split occurred in 2022 when the price of a single share was over $2,500. After the stock split, the price of a single share was brought down to around $120.
The company’s fundamentals stay exactly the same before and after a stock split. As such, there is no increase in value. However, stock splits do tend to have a significant effect on the price of the stock both after the announcement and after the actual split occurs.
As stated in the last question, stock splits do not affect the fundamental value of a company. As such, our recommendation would be not to invest in a company based only on whether it has split its stock. Instead, base the analysis on other factors that are much more important.