Stock Split – What is a Stock Split?
When a company performs a stock split, it has two 2 primary impacts – It increases the number of shares outstanding, and lowers the price of the current shares.
Stock Split Example
For example, a 2 for 1, or 2-1, stock split means that the company gives shareholders 2 shares for every 1 they currently own. If you had 100 shares of Apple and Apple announces a 2-1 stock split, you would then have 200 shares after the split occurs.
That sounds great, but it does not mean that you double your money instantly.
When a stock splits, the price of a share decreases. So, in our example above of an Apple stock split. If Apple was $500 per share before the 2 for 1 split, shares would then go to $250 per share.
If you had 100 shares when Apple was trading at $500 per share, your investment in Apple was worth about $50,000 (100 * $500).
After the 2 for 1 split, you would have 200 shares of Apple, which would now be trading at $250 per share. Notice that your total investment in Apple remains at $50,000 (200 * $250).
By this same reasoning, the market cap of the company also does not change.
Why Do Companies Split Their Shares?
So if a stock split does not change the value of an investment or the value of the company, why do companies do stock splits in the first place?
There are two primary reasons companies split their shares:
First, to lower the price of the shares.
Why would a company want to lower the price of its shares? Some feel that when a stock gets too expensive, it reduces demand from investors.
For example, as I write this Amazon shares are about $3,100 per share. If you only had $2,000 to invest, you may not be able to invest in Amazon at all!
For that reason, many companies like to have their share prices lower. This makes shares more accessible for more investors, which some believe should help increase demand and help the share price rise in the future.
Many retail investors frequently say that a stock split makes a company’s shares “cheaper”. This is right on the surface, but investors also receive much less of the company because each share represents less ownership after a stock split.
For more see our post here – “What Makes a Stock Expensive? Not Its Share Price!”
The second reason that companies split their shares may be to provide investors with more liquidity.
If there are a limited number of shares outstanding, investors may find it difficult to purchase shares without the price of the shares rising.
As an extreme example, say company XYZ has just 100 shares outstanding. If you are trying to purchase shares of the company you need to find the select few shares that are available. This may mean that you are unable to buy the shares at all if no one is selling, or the seller may demand a high premium knowing that the shares are scarce.
There have been several examples in the past where the lack of liquidity in a stock has led to some very dramatic action. For example, in the Panic of 1901, 2 railroad tycoons began desperately trying to buy shares in North Pacific Railroad. As very few people were selling, the price of the shares skyrocketed from $100 to $1,000!
By splitting the stock, the company issues more shares which should make it easier to trade. More shares outstanding means that smaller trades are easier to take place.
Reverse Stock Split
More often, a stock split results in the price of shares decreasing, and investors with more shares than they originally held.
But there is a different kind of stock split that does the opposite – A reverse stock split.
Under a reverse stock split, the number of shares outstanding decreases, and the price of shares increase.
Reverse Stock Split Example
For example, if Apple announced a 1 for 2, or 1-2 reverse stock split, investors would be given 1 share for every 2 shares they have. In addition, the price of the shares would double.
Using our Apple example. If you own 100 shares of Apple at $500 per share and Apple announces a 1-2 reverse stock split, you will then have 50 shares, and each share will be worth $1,000 per share.
Like with a normal stock split, this has no impact to an investment’s total value, or a company’s market cap.
Why Do Companies Do Reverse Stock Splits?
Many exchanges have requirements for a company to list their shares on an exchange.
For example, the NASDAQ requires that shares listed on its exchange have a price per share over $1 for long periods. If a company’s shares begin to consistently fall below $1 per share, the company must either enact a reverse stock split, or face having their shares delisted from the exchange.
We saw this happen regularly during the 2008-2009 banking crisis. Citigroup’s stock fell so much that the company was forced to perform a reverse stock split in order to ensure the shares were able to be traded still!
Here’s coverage from the Wall Street Journal at the time:
Should You Invest After a Stock Split?
A stock split has no material impact on a company’s value, or the value of its shares.
In the past it was very common to see companies frequently split their stock to keep share prices low.
However today that seems less common.
Berkshire Hathaway is one of the examples of a company that has never split its stock. Today, class A shares are over $340,000 each!
And other companies have follow Berkshire’s lead. Google and Amazon are two other notable companies who have not split their shares in a long time. Today both of these company’s shares are well over $1,000 each.
