What is a stock split?
A stock split is when a company decides to exchange its stock for more (and sometimes fewer) shares of its own stock. Many stock splits are greeted by investors as good news, and shares often rise as a result. However, some splits are seen negatively and may push the stock lower.
Here’s what you need to know about stock splits and why they’re not usually a big deal.
How a stock split works
When investors talk about stock splits, they’re usually referring to a forward stock split, but that’s only one of two major kinds of split. Here’s the simple distinction:
- In a forward stock split, your current shares are exchanged for more shares.
- In a reverse stock split, your current shares are exchanged for fewer shares.
When the split occurs, the share price also changes automatically to reflect the exchange ratio. That is, regardless of which kind of split, you’ll still own the same dollar value in stock as you did before the split. Think of it like slicing a pizza into more slices: The total area of the pizza stays the same, you just have more (smaller) slices that comprise the pizza.
Here’s an example to show how it works. Imagine you own 100 shares of a company that’s undertaking a 2-for-1 forward split and is trading at $100 per share before the split. Following the split you would own 200 shares but the price would be adjusted to $50 per share. So you end up with the same $10,000 in dollar value that you had before the stock split.
It’s a similar situation with a reverse split. Imagine you own 500 shares of a company that’s undertaking a 1-for-5 reverse split and is trading at $3 per share before the split. Following the split you would own 100 shares but the price would be adjusted to $15 per share. Similarly, you own the same $1,500 in dollar value that you had before the stock split.
Most forward stock splits are 2-for-1 or 3-for-1, though sometimes you might see a 3-for-2 split. Higher-priced stocks such as Apple may offer a higher exchange ratio, such as the company did in 2020 with its 4-for-1 split or its 7-for-1 split in 2014.
Why companies split their stock
Companies may split their stock for a variety of purposes, but they usually have little to do with the fundamental performance of the business. Mostly a stock is split for some or all of these basic reasons:
- To maintain the stock in a typical trading range. Stocks are normally priced in the range of $20 to $120 or so, and so companies may like to maintain that convention.
- To make it easier for investors to buy. A lower share price allows investors to buy a share with less money, though with fractional share investing that’s less of a concern.
- To increase liquidity. A more liquid stock may lower the bid-ask spread on the stock, making it less costly for investors to transact in the stock.
- To regain compliance with a stock exchange’s rules. A company may use a reverse split to push its stock price back over a certain threshold, typically $1 per share, in order to maintain compliance with an exchange’s rules.
- To raise the stock price. Some large investors are not allowed to buy stocks trading below a certain price, such as $5 per share. So a penny stock, which is often considered risky, may use a reverse-split to make its stock more acceptable to these investors.
These reasons for a stock split often have a lot to do with the stock price and technical aspects of trading rather than with the fundamental performance of the business. But consider why the stock is there to begin with, and splits seem to also be about the company’s fundamentals, too.
In other words, stocks that are rising a lot tend to have forward splits, and they’re rising a lot because they’re growing their profits and pushing the price higher. Conversely, stocks that have fallen tend to use a reverse split to move their price back into a “respectable range,” and they’ve also likely suffered a period of subpar performance or declining profitability.
So forward splits may indicate that insiders see the stock continuing to rise, while a reverse split may indicate that the stock may continue to fall. It’s this vote of confidence (or lack of it) that may help create a self-fulfilling prophecy for the stock undergoing the split, attracting investors who expect the stock to rise (or fall) based on the split and helping make it actually happen.
However, it’s key to remember that the split itself does not affect the value of your holdings.
Why do some companies not split their stock?
In recent times, it’s become more fashionable to let your stock run up without splitting it. The most famous example is Berkshire Hathaway, whose A series stock trades near $300,000 per share. Other large companies such as Amazon and Alphabet have share prices that trade in the thousands, while Apple often lets its stock run into the hundreds before splitting it.
These companies may not split their stock because a lower share price may attract investors who are not long-term-oriented and who would prefer to day trade rather than be owners of the business. So these companies may prefer investors who aren’t going to create volatility in the stock and otherwise hurt long-term investors who want to profit from the success of ongoing operations.
Mathematically, stock splits don’t mean much to stockholders, but they often seem to signal a subtle positive confidence from management in the continued rise of the stock. If management is splitting the stock because it wants to keep the stock in a typical trading range, then it’s ultimately a good sign that management remains confident in the stock’s eventual climb.
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