DEFINITION:
A stock split happens when a company divides each existing share into multiple shares, lowering the stock price.
A stock split happens when a company decides to divide one of its shares into more shares. For instance, they might turn one share into two. Even after the split, the total value remains the same. For example, if a company like ABC does a two-for-one stock split with an original share priced at $20, after the split, each new share would be priced at $10. So, if an investor had 50 shares valued at $20 each before the split, they would then have 100 shares valued at $10 each after the split.
During a stock split, investors who own shares don't change the total invested money, but they end up owning more shares.
Publicly traded companies, including large, valuable stocks, sometimes take steps to keep their stock prices within reach of more investors. They may do this through actions like acquisitions, launching new products, or buying back shares. As the stock price rises, it can become too expensive for many people to buy, which can affect how easy it is to trade the stock.
For example, imagine Company XYZ, a publicly traded company, announces a two-for-one stock split. Before the split, if you owned 100 shares priced at $80 each, your total investment would be $8,000.
After the split, even though the number of shares you own doubles to 200, and the price per share drops to $40, the total value of your investment remains the same at $8,000. This happens because the stock price adjusts after the split, keeping the overall investment value unchanged.
The usual kinds of stock splits are simple ones like two-for-one, three-for-one, and three-for-two. In a two-for-one split, investors get two shares for each share they had before. For a three-for-one split, they get three shares, and for a three-for-two split, they get three shares for every two shares they owned.
When a company's stock price becomes very high, a stock split could result in more shares being given for each share owned before the split.
Take the example of tech giant Apple. In August 2020, Apple split its stock four-for-one, meaning if you had one share before, you'd get four after the split. Before the split, one Apple share cost about $499.23, but after the split, the price was around $127. This made Apple's stock more affordable. It wasn't the first time Apple split its stock; it had done so five times since going public in 1980. In 2014, it split its stock seven-for-one, changing the share price from about $650 to around $93 after the split.
Another instance is Tesla, the electric car company, which split its stock five-for-one in August 2020. Before the split, one share of Tesla was roughly $2,213, but after the split, it was around $442.
On the other hand, Berkshire Hathaway's Class A stock, managed by Warren Buffett, never split, and one share was priced at a very high $327,431 in August 2020, making it unaffordable for most investors. To address this, Buffett created Class B shares, initially valued at 1/30th of the Class A shares. Later, after acquiring Burlington Northern Santa Fe, Berkshire split the Class B shares fifty-for-one, making them more accessible. As of February 2022, these Class B shares were priced at $313.96, making them more affordable for investors.
Pros
Cons
When a stock's price goes up to hundreds of dollars per share, its trading tends to decrease. By increasing the number of available shares at a lower price each, it adds liquidity. This narrowing of the gap between buying and selling prices helps investors get better deals when they trade.
When share prices are lower, it's simpler for portfolio managers to sell shares and purchase new ones. With lower prices per share, each trade represents a smaller part of the overall portfolio.
Selling a put option can cost a lot for stocks with high prices. A put option lets the buyer sell 100 shares of stock at an agreed price. The person selling the put must be ready to buy that set of stocks. If a stock is priced at $1,000 per share, the put seller needs $100,000 in cash to cover it. But if a stock is only $20 per share, they'd only need $2,000, which is more manageable.
One main reason companies choose to split their stocks is the potential to increase share prices. A study from Nasdaq examined stock splits by big companies from 2012 to 2018 and found that just announcing a stock split raised the share price by about 2.5%. Stocks that had undergone a split performed about 4.8% better than the market in a year.
Research conducted by Dr. David Ikenberry, a finance professor at the University of Colorado's Leeds School of Business, revealed that stocks which had split performed around 8% better than the market in a year and approximately 12% better over three years. Dr. Ikenberry's studies, published in 1996 and 2003, analyzed over 1,000 stocks in each research paper.
Another study by Tak Yan Leung of the City University of Hong Kong, Oliver M. Rui of China Europe International Business School, and Steven Shuye Wang of Renmin University of China also observed increased stock prices after splits among companies listed in Hong Kong.
Stock splits might make the market more unpredictable due to the new share price. When stocks become cheaper after a split, more investors might buy them, leading to increased ups and downs in the stock's value.
Some new investors wrongly believe stock splits are beneficial because they misunderstand the cause-and-effect relationship. A successful company often chooses to split its stock when it's doing well, as its book value and dividends may increase. If people see this pattern often, they might wrongly connect the two as always linked.
Certain stock splits, called "reverse stock splits," happen when a company faces the risk of its stock being removed from the market. Although the per-share price might rise after a reverse split, it doesn't mean the stock's overall value increases immediately, and it might take time to bounce back. Beginner investors unaware of this distinction might face losses in the stock market.
Forward splits, also known as regular splits, increase the number of shares you own while lowering the price per share. They are the opposite of reverse splits.
A reverse stock split usually happens when a company's share price is at risk of dropping so much that it might be removed from the stock exchange, preventing it from being traded.
It could be a good idea to stay away from a stock that has announced or recently finished a reverse split, unless you're confident the company has a solid strategy to improve its situation
An example of a reverse stock split is the United States Oil Fund ETF (USO). In April 2020, it had a 1-for-8 reverse stock split. Before the split, its price per share was around $2 to $3. After the split, the price went up to about $18 to $20 per share. So, if an investor had $40 and owned 16 shares of USO at roughly $2.50 each, they ended up with just two shares valued at about $20 each after the reverse split.
