Stock splits have been on the rise recently, with Amazon (NASDAQ: AMZN), Alphabet (NASDAQ: GOOGL), Tesla (NASDAQ: TSLA), and GameStop (NYSE: GME) among some of the well-known companies to announce they will be splitting their shares.
A split is a tool that companies, often with high stock prices, use to increase (or reduce) the number of existing shares and reduce (or increase) the face value of each share.
Here’s what you need to know about stock splits and how they are viewed by the market.
There are two types of stock splits: a normal (or forward) split and a reverse split.
What is a stock split?
A forward stock split occurs when a company decides to divide its stock, effectively increasing the number of outstanding shares.
After the split, a single share will represent a smaller portion of the overall company than it did earlier. Therefore, each share will trade at a lower price once the split is completed.
Increasing the number of shares outstanding makes a stock easier for people to buy and sell due to the lower price.
However, both forward and reverse stock splits don’t cause the stock to increase in value. Additionally, they don’t affect the total market capitalization of the company.
For existing shareholders of a company that has declared a forward stock split, this means that they will receive additional shares for each share that they already hold.
The best analogy is to compare a stock split to cutting a pizza.
First, the pizza is cut five ways, with five people getting a piece each. It is then cut ten ways, meaning all five people have two slices, but they still have the same amount of pizza.
The pizza simply becomes easier to share among a large group of people, but the quality of the pizza, and the amount, haven’t changed at all.
Depending on the company, stock splits generally take the form of:
- 2 for 1 or
- 3 for 1 or
- 5 for 1
Let’s say you own 200 shares in Company Y and each share is worth $10, for a total of $2,000. If the company announces a 2-for-1 forward stock split; this means you will now receive 2 shares for every 1 that you own, or 400 shares, with each share now being worth $5.
Even though you now own twice as many shares, the total value of your holing remains the same at $2,000.
Stock split examples
Here are a few companies that have carried out a forward stock split in recent history:
- Google-parent Alphabet announced a 20-for-1 stock split earlier this year, with an effective date of July 15, 2022. It is the company’s first stock split since April 2014.
- Online retail giant Amazon announced a 20-for-1 split in March this year.
- Nvidia (NVDA) did a 4-for-1 forward stock split on July 20, 2021.
- EV maker Tesla (TSLA) undertook a 5-for-1 stock split on Aug. 31, 2020.
- GameStop (GME), the company at the center of the meme-stock trading frenzy in 2021, is scheduled to carry out a 4-for-1 stock split on July 21 this year.
Reverse stock split
A reverse stock split occurs when the number of outstanding shares is reduced, and the price of the stock is increased.
For example, if a company authorizes a 1-for-2 reverse stock split, this means every 2 shares previously held will become only 1 share.
From our example, you would end up with 100 shares each worth $20. Again, the value of your investment is still the same at $2,000.
A company may carry out a reverse stock split when it believes the share price is too low to attract investors. Reverse splits may also be done when a company wants to regain compliance with the minimum bid price requirements of a stock exchange where its shares trade, according to the U.S. Securities and Exchange Commission.
While a reverse stock split can be good for a company since it helps them to remain listed on a major exchange, it is usually a sign of a company in distress.
Citi underwent a 1-for-10 reverse stock split in 2011 after its shares were pummeled by the 2008-09 global financial crisis.
General Electric completed a 1-for-8 reverse split in 2021 to support its stock.
Why companies split their stocks
There are plenty of reasons why a company’s board may approve a stock split.
As previously mentioned, a stock split does not increase the of value of a stock. Much of it comes down to making the stock more affordable to small investors and traders, and the behavioral benefits of that.
The following are the three main benefits that a company may realize after splitting its shares:
- Make shares more affordable: The main reason why companies split their shares is to bring down the price of an expensive stock so that investors can more easily buy and sell the stock.
If shares of a particular company rise too high, the price can push away new investors who may not be able to buy shares. Therefore, splitting the shares helps make them more affordable to more investors.
- Boost liquidity: A forward stock split raises the number of shares in circulation. This can significantly boost liquidity, thus making it easier to trade the shares. Increased liquidity is better for stock traders because it is easier for them to buy and sell stocks at affordable prices. High liquidity also means that trades can be executed much faster.
- Create more interest: A company that declares a stock split is often perceived to be a successful business. The fact that the price of its shares is so elevated that the stock has to be divided, implies that the company must be a good investment.
Disadvantages of stock splits
A stock split also comes with some disadvantages.
- It doesn’t change fundamentals: The underlying value of the shares remains the same, whether a company is undergoing a stock split or a reverse stock split. So, a stock split will not provide a long-lasting solution if a company is on the brink of bankruptcy or has weak fundamentals.
- They may attract the wrong crowd: Even though stock splits often make shares accessible to more investors, there is no guarantee a stock will draw the attention of investors who believe in its long-term success.
The extra liquidity that arises from a stock split may attract many short-term traders who are not most likely to stick with the company when it faces bad times. These traders look to capitalize on short-term price movements, which can be detrimental to the long-term success of the company splitting the shares.
Companies may decide to split their shares for a couple of reasons, but they usually have little to do with the fundamental performance of the business. Forward and reverse stock splits have zero impact on the value of the company or your holdings in that company.
But generally speaking, a forward stock split is viewed as a positive move because it makes shares of companies more accessible to everyday investors and traders. Reverse splits, on the other hand, may raise concerns about the future value of a company.
If a company announces a reverse stock split, this could mean that there is nothing on the immediate horizon that could improve the value of its shares. In this case, some individuals may prefer to put their money into a company that has a more promising future.