A stock split is when a company issues additional shares, dividing 1 share into multiple shares and therefore reducing the price of each share.
The dollar value of the total outstanding shares doesn’t change with a stock split.
A stock split is usually done when a company wants to boost its stock’s liquidity by increasing the number of shares in circulation.
The dollar value of the total outstanding shares doesn’t change with a stock split, but the value of each individual share does.
The split ratios seen most often in stock splits are 2-for-1 or 3-for-1 (could also be written as 2:1 or 3:1).
For example, if someone owned one share of a company for $90, after a 3:1 stock split they would have three shares that are worth $30 each.
How Does a Stock Split Work?
A company splits stock by increasing the amount of shares in circulation, so they issue more shares to shareholders based on the specified ratio of the stock split and the previously held shares.
A stock split can take the form of any ratio; it can be 2-for-1, 5-for-1, even 100-for-1.
It all depends on the company’s leadership and how they think the split will benefit the company and shareholders best.
Why Do Companies Split Their Stock?
When a company’s stock price gets too high, it becomes inaccessible to a large pool of potential investors.
In order to tap into these investors and provide a more comfortable investing stock price, a company may choose to split its stock.
An investor may find more comfort investing in 50 shares at $20 per share versus investing in 1 share at $1,000 per share.
A higher number of shares also results in higher liquidity which can narrow the bid-ask spread and facilitate higher trading volume since its lower dollar value is easier to buy and sell.
In 2020, Apple did a 4-for-1 stock split.
At the time, AAPL was trading at around $540 per share, and after the split it dropped down to $135 per share.
The accessibility of the lower share price is likely to have positively benefited the company and contributed to the 28% increase.
The opposite of a stock split is known simply as a reverse stock split.
Did You Know?
Warren Buffet, Chairman and CEO of Berkshire Hathaway, has never split the company’s stock, despite it being the most expensive stock in the world. Class A shares of Berkshire Hathaway Inc. cost over $500,000.
Pros of Stock Splits
Improving Liquidity
Since stock splits increase the total number of shares in circulation, the price per share decreases and becomes more affordable.
Investors with smaller account balances can take advantage of this and execute more frequent trades which increases demand and could drive the price up.
Since the bid-ask spread is also decreased, the benefit to investors and incentive to trade more could benefit the company in the long run.
Increasing Shares Outstanding
Instead of releasing more shares in an official second offering, a company can opt to split the stock and increase shares in circulation without facing stock dilution.
Bringing In More Investors
Lower prices for shares can attract smaller investors as mentioned before.
Investors can benefit from greater affordability, potential increase in the price of the shares, access to new ways to diversify and rebalance their portfolios, and higher liquidity.
Increased Market Activity
With a lower bid-ask spread and greater affordability, a stock split can stimulate higher trading activity through exchanges and brokers.
The higher demand directly benefits the company and investors.
Cons of Stock Splits
Cost to Company
From announcement to execution, stock splits cost money and are time investments for the company.
Usually, a financial institution is hired to carry out the split and the service costs a fee.
Potential to Bring in the Wrong Type of Investors
Some investors aren’t committed to the long-term success of the company and only want to capitalize on market trends for personal gain.
Long-term investors are key to the success of publicly traded companies and lowering the price per share can bring in the types of investors that don’t necessarily care about the long-term vision and future of the company.
No Change to Fundamentals
Stock splits don’t fundamentally change the value of a company.
If nothing changes after the stock split in terms of operations and improvement, the split can be considered meaningless.
Does a Stock Split Make You Money?
The stock split itself does not make investors any money.
It does however imply that a company is doing well and wants to increase affordability to small investors.
If a company is on an upwards trajectory, there is a good chance that the split will help increase its overall valuation, and in turn increase the value of each share a shareholder owns.
