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The word stock split can sound like a complicated financial stunt when you hear it. But it is an idea that even novice investors can readily understand. In simple terms, a stock split is where an organization resolves to split the shares that it has into additional shares.
This adds to total number of shares outstanding but it does not alter the value of your investment. Although stock splits may not be an obvious choice of words, it is a typical corporate activity that can result in tremendous effects on share price, liquidity, and investor confidence.
In this blog, we will deconstruct what a stock split is, how it is executed, why companies decide to engage in it, and what it could imply to you as an investor. Let’s dive in!
What Exactly Is a Stock Split?
Stock split, when a company issues more shares to its stockholders, is a division of the stock in which each share is divided into several new shares. This causes a total increase in the number of shares although the value of an individual share is reduced proportionately. Notably, the sum of your investment is not reduced.
As an example, when you have 100 shares of a company that trades at a price of $1,000/share, your investment will be 100,000. Should the company declare 2-to-1 stock split, you would have 100 more shares and the price of the new share would be worth 500 dollars. Yet, your cumulative investment would be still be 100k. Here’s a breakdown:
Pre-Split: 100 shares at google stock split $1,000/share = 100, 000 total investment. Split: 200 shares of the stock, each share costing = 500 = = 100,000 total investment.
The moral here: You own more shares, but at a lower price. The split does not have an impact on the intrinsic value of your investment.
The Reason Why Companies do Stock Splits?
A company may choose to adopt a stock split due to a number of reasons. And now we should take a more detailed look at the most popular ones:
1. Making Shares More Affordable
The stock split is one of the most frequent reasons why the shares are made more accessible to individual investors. High stock prices such as Amazon or Tesla could push the price of shares in the thousands of dollars, making small shareholders unwilling to buy stock.
The share repurchasing by stock split means that the price per share is lower and affordable to the retailing investors. This does not alter the worth of the company but it enables more individuals to trade the stock.
As an example, when the stock of a company is valued at 2000 dollars per share and there is a 10-to-1 stock split, the price reduces to 200 dollars per share and is more appealing to a broader market.
2. Increasing Liquidity
As the company issues more shares, so does it enhance the liquidity of the stock. Having a large number of shares will make it easier to buy and sell the stock and this can add to the decrease of volatility. Greater liquidity has also been found to be of advantage to the institutional investors who usually deal in large volumes.
3. Signal of Growth and Confidence
Stock split is considered to be a good indicator by the management of a company. This normally occurs when the price of the stock of a business has been growing steadily and they would like to hold the shares in a price that is affordable to the typical investor. The stock splits usually occur in companies that are confident in future developments. As an example, both Apple and Tesla announced stock splits following notable rise in stock prices, which indicated their prospects of growth and dedication to shareholder value.
4. Aligning with Peers
In other situations, firms can carry out stock splits to make their stock prices meet the prices of other firms in the same industry. When a firm has an overvalued share price relative to other firms in the industry, then the company may conduct a stock split to ensure that prices remain competitive.
The Impact of Stock Splits on Investors
To an investor, stock splits tend to be a neutral phenomenon although they can be positive or negative.
Positive Effects:
- Higher Accessibility: When a stock is split, increased share prices are accessible and thus retail investors can easily purchase shares. This can cause an increase in demand that can cause an upward push in the stock price in the short-run.
- Good Market Feeling: Market splits have a tendency of bringing optimism. Investors could take stock split as an indicator of a healthy company and this could raise the stock demand.
Negative Effects:
- No Better than a Split of Stock: Stock splits give you more shares to own, but they do not add value to your investment. What you are getting is a more number, but lesser value shares so that the total value of your holdings is the same.
- Volatility Risk: In case the stock price increases rapidly following a split, it could be attracting short-term traders who would cause volatility in the stock price.
Types of Stock Splits
Stock splits tend to be forward splits but a reverse stock split is also possible. Here’s how they differ:
Forward Stock Split:
The most common type is a forward stock split, in which the company does a proportional increase in the number of shares and a proportional decrease in price per share. For example:
- 2-for-1 split: You are issued two new shares in place of one share that you already own and the price per share is reduced by fifty percent.
- 3-to-one split: Each share of the stock held by you is issued three more times and shares are sold at a third of their original price.
Reverse Stock Split:
In contrast, a reverse stock split is a share consolidation. As an example, during a 1-for-10 reverse stock split, you would give up 10 shares in exchange of 1 new share, and the price of a share would increase by 10. The most common reason why companies take on a reverse split is when their stock price is too low or when the company requires a minimum price to be listed on an exchange.
Conclusion
Stock split is a device used by companies to make shares more liquid, affordable, and as an indicator of growth. Although a stock split does not alter the total value of investors holding, it may impact the perception of the stock and may more easily allow more people to invest. Knowing how to interpret the effects of stock splits as a US investor can assist you to make informed decisions and learn how to interpret the effects of this corporate activity on your portfolio.
When you are thinking of investing in a company that has decided to split its stock, then you should remember that the split is not what will alter the base of the company. Before making investment related decisions, it is necessary to examine the growth opportunities, financial status and long term planning of the company.
