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The stock market is a great way to generate wealth. It helps inch closer to your personal finance goals as you make money through dividends and capital appreciation. One form of dividend is a stock split. Although it is not very common, it has gained popularity over the past few years and is one way for companies to grow.
Oftentimes, a company is worried about whether their share price is very high or very low and this is when they consider a stock split. It can help the company lower the share price and make it more appealing to the investors. On the other hand, a reverse stock split helps boost the share price and in many instances, helps preserve the listing on the stock exchange.
In this article
Understanding a stock split
When the management of a company issues more shares of stock for the present shareholders without any dilution in the value of their stake, it is known as a stock split. It helps increase the number of outstanding shares and reduces the value of the share. Despite the shares outstanding changing, the market capitalization of the organization as well the value of every shareholder’s stake will remain the same.
So if you have a share of a company and the company goes for a 2-for-2 stock split, then it will grant you two new shares but the value of the shares will be half the amount of the original. Hence, post-split, you will have four shares of the same value as the single share you originally held.
Mutual funds also split the same way an individual stock does but less often. The split does not result in any change in the net asset value and works mainly as a marketing device.
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Reverse stock split
In the event of a reverse stock split, the company will reduce the number of shares. Let us assume you had 10 shares in the company, and the company announced a 2-for-1 reverse stock split, you will now have 5 shares of the stock. Thus, the value of the shares remains consistent and if the 10 shares were valued at $5 each before this move, the same shares will be valued at $10 each after the reverse split. Your value of the investment will remain the same.
The purpose of a reverse stock split is to help a company meet the minimum requirements in order to remain listed on the exchange since it is possible to get kicked off when the price of the stock dips too far. It is best to avoid the company that has recently gone through a reverse stock split.
Purpose of stock split
A stock split is a financial strategy that is used by companies for a certain goal. It helps create additional liquidity by making the price highly attractive for investors. When the value of a stock is very high, not many people will be willing to invest in the company. You may not be able to buy Apple stock at $600 but you can buy it for $150. It will allow more people to access the shares and will keep the existing shares liquid.
Types of stock splits
Some of the most common types of stock splits are the traditional stock split ratios, like 2-for-1, 3-for-1, or 3-for-2. In a 2-for-1 stock split, the shareholder will receive two shares for each share held. Similarly, in a 3-for-1, the shareholders will receive three shares for every share held and in a 3-for-2, the shareholders received three shares for every two shares held. Apple and Tesla recently gained publicity for their uncommon 5-for-1 and 4-for-1 stock split choices.
When the stock price of a company has increased significantly, there can be more shares that are exchanged for one share held. Apple went through a stock split in 2020 where it split the stock 4-for-1. This means all the shareholders who held one share of the stock are now holding four shares. The price of AAPL stock before the stock split was $499 and after the split, it stood at $127 each. It made the stock more accessible to the investors.
Interestingly, companies announce stock splits often and for Apple, this was the fifth stock split since the IPO. Previously, it had announced a 7-for-1 stock split. For investors who had purchased the stock during its IPO, the number of shares held is only increasing with each stock split.
There are many other examples including Tesla, which split the stock 5-for-1 last year. Before the split, the stock was trading close to $2,200 and was out of reach for many investors but after the split, it was about $440, making it easily accessible for many.
However, not all companies that have their stock soaring are happy to split the stock. One example is Berkshire Hathaway class A. The company has never split stock and it is trading at $517,000 today. The stock is outside the realm of many and most investors in the world may not be able to own a single stock of the company. Later they did create a Class B share which is much more accessible for investors today.
Impact of a stock split on investors
A stock split does not change the value of your investment, but you will notice substantial changes in the total number of shares you hold. If you already have the shares, nothing about the ownership will change for you. But you may have more shares at a lower price, so it is all balanced.
But those who aren’t investors in the company, a stock split could be a huge motivation to invest. It is possible that one cannot afford to own the share of Alphabet before the stock split but after the split, the price will become low and it will be possible to get one. When stock becomes accessible, it increases the ability of people to own the stock and helps increase the stock price, which ultimately, may increase the value of the company.
When more people buy a stock, there is higher demand and its price goes up. When you have more shares, it is beneficial if you hold on to them. It is important to keep in mind that the bump involved is usually temporary and to make gains, you need to hold the stock.
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Importance of stock splits amidst fractional share investing
Fractional share investing has become very popular and appealing. Since fractional shares make it possible for you to own stock in the company at any price, stock splits might become less important over the coming years. Apps including Robinhood, SoFi, and M1 Finance offer fractional investing in stocks and exchange-traded funds (ETFs) and make it easier for investors to own any stock at a minimum amount.
However, it will take a lot more time before fractional investing puts an end to the need for stock splits. The psychological impact of stock splits can never be underestimated. Investors love a big number and they would love to add new shares of the stock they own without having to pay for them.
Upcoming stock splits
Here are some of the much-awaited stock splits happening this year.
Amazon
E-commerce giant Amazon announced a stock split last month. The company will go for a 20-for-1 stock split and it will be effective from June 6. Amazon stock is worth $3,000 as of this writing which could be one reason for this move. However, the company’s business looks solid and there is a lot of room to grow. The company is a leader in several industries and is constantly gaining market share.
It holds the top spot in e-commerce and is a major player in the music streaming industry as well. It is expected that the company will continue to invest in multiple lines of business and remain at the top of the markets. The stock split will make the stock more affordable for new investors.
Alphabet
Google’s parent company, Alphabet announced a 20-for-1 stock split which will be effective on July 15. This means each shareholder will receive 19 additional shares for one share held. The company has seen its market valuation inch closer to trillions over the past few years. Alphabet shares are trading at $2,534 and this has made them out of reach for several investors. With the stock split, the shares will dip in price and more investors might be able to afford to buy them. The future of Alphabet is bright with cloud computing as it is consistently recording big numbers in revenue and growth.
Shopify
Shopify is another major e-commerce company that announced a 10-for-1 stock split on April 11. However, this move is yet to be approved and will be finalized at the shareholder meeting on June 7. The shares are currently trading for $580 and the split will reduce their price significantly. There is a lot to like about Shopify, right from the growing number of merchants on the online storefronts to the massive surge in online shopping. The company is consistently expanding its offering and making it easier for merchants to sell goods on the platform. Its client base is growing at a frantic pace but there is still plenty of room to grow.
Tesla
Following the steps of Amazon and Alphabet, Tesla has also filed to seek investor approval to increase the number of shares. The proposal has been approved by the board of directors but the shareholders are yet to vote on it. If approved, the company will have another stock split after the 5-for-1 split in 2020. After the 2020 stock split, Tesla's share has increased close to 130% and is trading at $985 today. The company will announce the split ratio and record date at the annual meeting.
Related: How to Buy Tesla Stock – Pay No Fees
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Pros & Cons
Pros
- Helps improve liquidity. In case the stock price rises by a few dollars per share, it will reduce the trading volume of the stock. With a split, there will be a rise in the number of outstanding shares but at a lower price which will add liquidity. This will narrow the spread between the ask and bid prices and allow investors to enjoy better prices whenever they trade.
- Helps rebalance the portfolio. With a dip in the share price, portfolio managers will find it easier to sell the shares and buy new ones. This will help rebalance the portfolio.
- Makes stock more accessible. Since the stock split increases the number of shares outstanding, there will be a dip in the stock price and it will become more accessible to investors. This will lead to a rise in the demand for the stock and will benefit the company.
Cons
- Increases volatility. There is high volatility in the market post-split. This happens due to the new share price since it becomes accessible and investors may decide to buy it. This will lead to higher volatility in the stock price.
- Reduces share price. The purpose of a stock split is to make the shares accessible to investors and with an increase in the number of shares, the stock price will reduce.
The bottom line
A stock split does not have a big practical impact on the current shareholders but its biggest impact is on new investors. The ones who are waiting and watching for the stock to dip so that they can purchase it. For those investors, stock splits are a great motivator to take their position. Investors do not lose money due to the split, but if you will make money in the long term will depend on various circumstances of each company’s situation and the performance of the stock market as a whole.
Companies including the blue-chip stocks do stock splits. As the firms continue to grow in value, the quoted market value of the stock will become too expensive for investors to afford and this starts to influence the market liquidity as there are fewer people capable of buying a share. Inexperienced investors believe that stock splits are a great thing since they mistake correlation and the cause. The company which is already doing very well will consider a stock split since the dividends and book value continues to grow. Stock splits are considered a positive growth move for the company.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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