Understanding Stock Splits

‘Stock splits’ is an interesting strategy that has always remained in the debate in financers and investors. What is it? How does it work? And why companies choose this method? Does it have something to offer you? If you have all these questions in your mind, you should read this article to understand split stocks.

What is Stock Splits?

Any company’s board of directors decides to take this action known as the stock split that raises the number of outstanding shares of that company. This happens by dividing every share by the required number of shares. That said, this method doesn’t have a great impact on the company’s market capitalization. Moreover, the value of shares remains the same. For instance, a $100 bill’s value can’t change if you exchange them for two $50 bills. This is why when this split occurs, a person holding shares will get an additional share for each share. However, the value of every share becomes half. So, now the value of two shares is the value of one share before the split.

For example, a company trades stock “A” at $40 and has a total of 10 million shares used. This means the market capitalization of the total shares is $400 million. Then the company decides to use the 2-for-1 stock split. For every share, shareholders get an additional share. This is how they have two shares for every share they already have. However, the stock price now gets reduced to 5%, i.e., from $40 to $20. It also shows that the shares’ market price remains the same, which is $400 in total, but the total number of shares is now 20 million. In short, the value of the company does not change.

Why do Companies Split Stock?

There are many reasons why a company considers stock splits. The primary reason is psychological behavior. When shares’ price becomes higher and higher, some investors think it is too high to buy. Other small investors consider it unaffordable. So, when a company splits its price, it becomes more attractive to potential investors. It is important to understand that the actual price of the stocks does not change, while the lower price of the shares may change the perception of investors about the particular stock, which attracts new investors. It is also great for shareholders who already have shares. They think that they suddenly got more shares than before. Not to mention, of course, they feel great that if the price increases at any time, they have a good amount of stocks to trade.

Another reason that is pretty logical: the company splits stocks to increase stock liquidity. This raises the number of outstanding shares. Stocks sold with the higher value of hundreds of dollars each share can give you large bid/ask spreads.

Yes, it is crucial to understand that in the context of a company, these reasons don’t have any potential effect. Any finance professors will tell you that it is totally irrelevant, yet popular companies still do it. But there is something you can learn from it. Splits demonstrate that corporate action and investor behaviors are not always necessary because of financial theory. This unique understanding of human and finance relation has opened a new area to study known as behavioral finance.

Types of Stock Splits

The traditional stock split is also known as further stock splits. These splits have different types, but the most common ones are 2-for-1, 3-for-1, and 3-for-2. In the 2-for-1 split, a shareholder gets two shares for each share they already have. Moreover, 3-for-1 indicates that a person will get three shares after the split. The 3-for-2 splits divide two shares into three shares; a shareholder will get three shares for every two. You can also see an even higher number of splits if a company’s stock price becomes very large.

One of the major and known examples of stock splits is Apple. On August 31, 2020, this tech giant split their stock 4-for-1, which means investors who have one share now get three more for one share. This means they have four shares in exchange for their three shares. Before the split, each share of Apple was $499.23. After the split, it becomes $127 each. This split stock has made Apple’s share more accessible to investors. However, this is not the first time that Apple has taken this step. You will be surprised to know that this is their fifth split since Apple’s IPO in 1980. Not to mention, in their second last split, they opted for the 7-for-1 split.

Take another example of Tesla, the popular electric car company. Tesla went for the 5-for-1 split on August 31, 2020. Before the split, each share value was $2,213. But after the split, the value of each share becomes $442.

You may be wondering why some companies don’t opt for the splits. In this case, a great example is Berkshire Hathaway. In these years, Warren Buffet has never opted for the splits. As of August 2020, each Class A share of Berkshire Hathaway was $327,431. While they have a higher value of each share, they don’t have decided to divide anytime soon.

Buffet has created Class B shares. It gives you an example of a dual-class structure. You can convert the Class A share into Class B, but can’t exchange class B share into Class A. Berkshire Hathaway has decided to split their class B share because of the higher value. They split their stock 50-for-1, so every class C share has a small value than the Class A share. As of August 28, 2020, class B shares have traded at $218.55, which is easier for investors to invest.

What Are Reverse Stock Splits?

You can say that Reverse Stock splits are the opposite of the traditional stock split. This means that you will get a few shares that you have before the split at a higher per-share cost. A corporate implements a reverse split when its per-share gets in danger of becoming extremely low that the stock can be delisted. It means that the shareholder will get into a position where they can’t trade on an exchange.

This is crucial to understand. Investing in the shares that have gone through a reverse split is totally a useless approach unless you have a strong point to believe that the company has a sound plan to raise their value of the stock.

One of the known companies that have undergone the reverse stock split is the United States Oil Fund ETF (USO). On April 22, this company opted for the reverse stock split that was 1-for-8. The price of each share before the split was around $2 to $3. After the reverse stocks split, per share becomes $18 to $20. If a shareholder has 16 shares worth $40 in which each share costs $2.50, they have to get two shares worth around $20 each after the split.

Why Split Stock Shares?

For an investor, split stocks are great for some reason. Suppose a person wants to invest in a stock but don’t have enough money to purchase, even a single share of that stock because of the higher price. In that case, they can enjoy the advantage of stock splits. The split allows them to purchase a share at least half of the price of the original share. So, shareholders who have little money to invest can buy stocks of great companies at a lower price.

Moreover, the splits method also helps in the trading process. More shares provide greater liquidity, making it easier to sell or buy the share when there are more in the market. When the value of each share is high, the spread between the bid price and the ask price can get higher, making stock trading challenging. These are the reason why splits are great for some investors.

However, you need to keep in mind that some companies intentionally split their stock to make people assume the value of each share is increasing. This is why some investors think it is worth investing in. However, this is a trap to sell their shares.

Why Not Split?

Yes, this is true that there is no great evidence of whether stock splits matter or not. As we have already mentioned, finance professors don’t see any great impact of splits on a company’s value or performance.

A huge number of companies never split their shares because they believe that it is a symbol of a strong company to have a higher value of each share. For instance, a company trading each share worth $1,000 may be considered valuable even if they have the same market capitalization as a company that has each share worth $50.

Smaller companies also avoid splits, as it can lower the value of each share greatly. You may have seen companies splitting their shares to check the stock market dive, offering shares as below as $10. In terms of psychological impact, it does its work to attracting some shareholders. However, share prices become too low for a company to come to the list of exchanges. This is why some companies protect themselves from getting into this type of position.

How Do a Stock Split Help Old Shareholders?

As the splits don’t change the value of shareholder’s investments, you will not observe any great change in your shares, except the number of shares in your investment account. In other words, there is no particular advantage for shareholders that already have shares of stock. Noting in terms of ownership will be going to chance. You only have twice of the shares you already have.

As we have already discussed, it has some benefits for the investors who don’t have shares of that particular company. As the split increases the ability to buy the share of many people, it increases the demand for the shares. The demands can be higher the value of each share, at least temporarily. So, if you have many shares in the stock, you can take advantage of the split if you hold on for some time. But keep in mind the increase in the value of the stocks is temporary.

Is Splits Necessary Anymore?

Of course, they are. As we have already discussed, many investors think they need a great amount of money to invest in any particular stock or buy a single share. But splits have made it possible to purchase shares. Different platforms or sites can help you to buy fractional shares. Some of the common and known examples are Betterment, Stockpile, M1 Investing, Motif, and Stash. Moreover, these apps are easy to handle and have come into the market in the past few years to help investors spend a small amount of money.

Furthermore, if interested, you can go for another unique method to buy shares. This method is mutual funds. Many people own shares through this method, which allows them to own stocks without necessarily buying full shares outright.

Bottom Line

In a nutshell, stock splits are great for people who don’t have enough funds to invest in a particular company’s stock. It is also great for shareholders who have already have these shares, only if the value increases suddenly because of the higher demand.

However, there are no particular benefits of splits for the companies as their market value remains the same before and after the slit. But the split can be dangerous for them if they have a lower value of each stock. Additionally, some companies use this method to play with the minds of investors. When they split stocks, investors consider them a great company to invest in and think that this company’s value will be increased.

However, this is only a trick to catch the attention of more investors. So, it’s crucial to do your research before buying stocks. Once you get satisfied, buy shares of the company that have recently used the method of the split.

Engage with the entire King Financial Network team on www.kingfn.com to see what other expert advice we can provide towards your financial well-being.

Alyson Mandato is a Wealth Management Assistant and provides assistance to the KFN team in all aspects of financial strategies.

King Financial Network is an integrated, team-based network that takes a comprehensive, customized, and independent approach to guide you through Financial, Retirement, Tax, Insurance, and Estate Planning.

Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser.

Sources

• https://www.nerdwallet.com/article/investing/what-are-stock-splits
• https://www.thebalance.com/understanding-stock-splits-3141376
• https://www.investopedia.com/articles/01/072501.asp
• https://www.upcounsel.com/disadvantages-of-stock-split
• https://www.thebalance.com/why-wont-amazon-split-its-stock-4173019
• https://www.investopedia.com/terms/s/stocksplit.asp