Whether you’re a novice, seasoned investor, or simply like to keep up with financial market news, you will have likely encountered the term “stock splits.” If you have had a hard time grasping this concept, here’s a simple way to think of it using one of the most common analogies.
Imagine you have five friends and you order a pizza worth $10. The pizza comes sliced into a specific number of pieces, let’s say five slices. Each person will have a single slice of the pizza, but it’s still the same singular pizza. If you were to contribute equally to buy it, then everyone would pay $2. If more friends show up, you can divide the slices of pizza you already have into more pieces based on a given ratio to accommodate them.
Let’s say you’re joined by five more friends. Each of the slices can be divided into two, which would make the total slices available ten. Remember, this is still the same single pizza you ordered, so it retains its initial value. The only difference is that you have divided it into even smaller portions, so if all of you were to contribute equally, you would now pay $1 each. This example represents a 2-for-1 split.
So, when a company splits its common stock 3-for-1 in the context of investing, it means that if it had 1000 outstanding shares worth $30 each before, the current number of shares would become 3000 with a value of $10 each.
How Stock Splits Work
So how do stock splits work? There are two types of stock splits. The most common type is the forward split, where a company increases the number of outstanding shares by issuing new shares to existing investors. The other type is the reverse stock split, which works in the opposite way. The company decreases the number of outstanding shares and raises the price of each share.
When a company goes public during its initial public offering (IPO), it sells a fixed number of shares to investors. However, after the IPO, the company can issue more shares in order to raise money. This process can lead to stock dilution since it reduces the ownership proportion of existing shareholders.
Unlike the process of issuing new shares, a stock split divides each share into multiple ones according to a specified ratio. Significantly, it does not dilute the ownership interests of existing shareholders.
All publicly listed companies have a specific number of outstanding shares of stock that have been bought by and issued to investors. So, for a stock split to occur, the company’s board of directors has to approve the decision. Furthermore, investors need to be aware that a stock split doesn’t mean that the value of their holding increases. The number of shares and the price will have an inverse relationship — i.e., as the number of shares increases, the price of the individual shares decreases.
Real-Life Examples of Stock Splits
Apple announced a 4-for-1 stock split during its third-quarter 2020 earnings report, with an effective date of Aug. 31, 2020.
Tesla announced a 5-for-1 stock split along with its second-quarter 2020 earnings report, also with an effective date of Aug. 31, 2020.
Alphabet (NASDAQ: GOOGL)(NASDAQ: GOOG) completed a 2-for-1 stock split in 2014, but the newly-created shares were nonvoting class, which is why there are now two publicly traded Alphabet ticker symbols.
If you are wondering how to find a stock split history, the company’s annual report could be a great resource. Or, you can access popular charting sites like Yahoo! Finance and click on the ‘Events’ button.
Possible Reasons for a Stock Split
So, why would a company want to double or triple its outstanding shares if this would not increase the company’s overall value? For starters, a stock split corporate action can be a great avenue for companies looking to draw in more retail investors. This is especially true for companies that are experiencing accelerated growth.
A company that is growing or believes it will grow may decide to split its stock to give investors a positive impression of its prospects. The company shares become more affordable, thus reducing the amount of initial capital required to invest in it and allowing smaller investors to buy into the company.
One other clear benefit that is often overlooked is that a stock split will increase liquidity, or how easy it is to sell a stock. The more outstanding shares that a company has, the more shares that are available to trade. This is also instrumental in lowering the price volatility and the difference in bid-ask prices, making the stock a more attractive investment.
How Stock Splits Affect Your Portfolio
Now that you are familiar with the concept, you might be wondering how stock splits affect your portfolio. While stock splits don’t necessarily guarantee that a stock price will go up, they do have a number of implications for your portfolio.
For instance, as a result of the lower barrier to entry due to a reduction in share price, stock splits are usually followed by an uptick in market activity due to increased investor interest. This can lead to an improvement in the stock performance over time. In fact, one study found that companies that initiated stock splits saw a marked improvement in their share price of roughly 8% within the first year. Tesla’s stock seems to reaffirm this finding considering that it gained an impressive 85% in just five months following its stock split.
Also note that if the company pays a dividend, the dividends paid per share will decrease proportionately to the split.
Stock splits can also help investors to diversify. Since there are more shares and share prices are lower, it is easier to diversify and rebalance portfolios. Finally, the upside potential of the stock increases since a stock with a lower price has more room to run than one with a higher price. Also, as price increases, it tends to have a greater impact on an investor’s holding since it accounts for a greater portion of the company’s value.
Featured Image: Twenty20
