Understanding Stock Splits: Examples, Benefits, and Drawbacks

Stock splits are a common occurrence in the financial world, often generating significant interest among investors and market analysts. This article delves into the concept of stock splits, providing examples, highlighting benefits and drawbacks, and exploring their implications for investors.

What is a Stock Split?

A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the stock's liquidity. While the number of shares increases, the total value of the shares remains the same compared to pre-split amounts because a split does not add real value.

For example, in a 2-for-1 split, each shareholder receives an additional share for every share they own, doubling the number of shares they hold, but the price of each share is halved.

How Does a Stock Split Work?

Example of a Stock Split

Let's consider a hypothetical company, TechInnovate Inc., which has 1 million shares outstanding, each trading at $100. The company's market capitalization is $100 million. If TechInnovate Inc. announces a 2-for-1 stock split, each existing share is divided into two. After the split, the company will have 2 million shares outstanding, and the share price will be adjusted to $50. The market capitalization remains unchanged at $100 million.

Reverse Stock Split

A reverse stock split is the opposite of a stock split. In a reverse split, a company reduces the number of its outstanding shares, thereby increasing the share price. For instance, in a 1-for-2 reverse split, every two shares are consolidated into one. If TechInnovate Inc. performs a 1-for-2 reverse split, the number of shares outstanding will be halved, and the share price will double.

Reasons for a Stock Split

Improve Liquidity

One of the primary reasons companies perform stock splits is to improve the liquidity of their shares. A lower share price makes the stock more accessible to a broader range of investors, particularly retail investors. Increased trading activity can lead to tighter bid-ask spreads and more efficient price discovery.

Enhance Marketability

A high share price can sometimes be a psychological barrier for small investors. By splitting the stock and reducing the per-share price, companies can make their stock more attractive and affordable, thereby enhancing its marketability.

Signal of Confidence

A stock split can be interpreted as a signal of confidence from the company's management. It often indicates that the company expects continued growth and wants to make its stock more appealing to investors.

Comply with Listing Requirements

Sometimes, companies perform reverse stock splits to comply with minimum share price requirements set by stock exchanges. Falling below these requirements can result in delisting, so a reverse split can help maintain a company's listing status.

Attracting Institutional Investors

Certain institutional investors, such as mutual funds, may have policies that prevent them from purchasing shares priced below a certain threshold. By performing a reverse stock split, companies can increase their share price to a level that is more attractive or permissible for these large investors, potentially increasing institutional ownership.

Examples of Notable Stock Splits

Apple Inc. (AAPL)

Apple Inc. is renowned for its stock splits. One of the most notable was the 7-for-1 split on June 9, 2014. Before the split, Apple's share price was around $645. After the split, the price adjusted to approximately $92 per share. This split made Apple stock more accessible to a broader range of investors, contributing to its liquidity and marketability.

Tesla Inc. (TSLA)

Tesla Inc. executed a 5-for-1 stock split on August 31, 2020. Prior to the split, Tesla's share price was around $2,213. After the split, the price adjusted to about $442.60 per share. This move was aimed at making Tesla's shares more affordable for individual investors and increasing the overall liquidity of the stock.

Alphabet Inc. (GOOGL)

Alphabet Inc., the parent company of Google, performed a 20-for-1 stock split on July 15, 2022. Prior to the split, Alphabet's shares were trading at over $2,400 each. After the split, the share price was adjusted to approximately $120. This split was intended to make the stock more attractive to retail investors and improve its trading volume.

Amazon.com Inc. (AMZN)

Amazon.com Inc. announced a 20-for-1 stock split on June 6, 2022. Before the split, Amazon's share price was around $2,785. Following the split, the share price was adjusted to approximately $139. This split was part of Amazon's strategy to make its stock more accessible to a wider range of investors and improve liquidity.

Benefits of Stock Splits

Increased Liquidity

Stock splits generally lead to increased liquidity due to the higher number of shares outstanding and the lower price per share. This can result in more trading activity, tighter bid-ask spreads, and better price discovery.

Enhanced Accessibility for Retail Investors

Lower share prices make stocks more affordable for retail investors, allowing a broader range of individuals to invest in the company. This can lead to a more diversified investor base and potentially increased demand for the stock.

Positive Market Perception

A stock split can be seen as a positive signal by the market, indicating that the company's management is confident about its future prospects. This can boost investor sentiment and potentially drive the stock price higher over time.

Potential for Higher Valuation

While a stock split itself does not change the company's market capitalization, the increased accessibility and liquidity can attract more investors, potentially leading to a higher valuation over the long term.

Greater Flexibility for Option Traders

Stock splits can also provide greater flexibility for option traders. Options contracts typically represent 100 shares of the underlying stock. After a stock split, the lower share price can make options contracts more affordable and accessible, increasing their attractiveness to a broader range of traders.

Drawbacks of Stock Splits

No Change in Fundamental Value

A stock split does not affect the company's fundamental value. It is merely an accounting adjustment that increases the number of shares while reducing the price per share. Investors should be cautious not to interpret a stock split as an indicator of intrinsic value.

Potential for Increased Volatility

The increased trading activity following a stock split can sometimes lead to higher volatility. While this can present opportunities for short-term traders, it can also increase the risk for long-term investors.

Cost and Complexity

Executing a stock split involves costs related to regulatory compliance, administrative adjustments, and communication with shareholders. These costs can be significant, particularly for smaller companies.

Market Misinterpretation

There is a risk that investors might misinterpret a stock split as a sign of a company's intrinsic value or future growth prospects. This can lead to overvaluation and subsequent market corrections.

Impact on Dividend Payments

For companies that pay dividends, a stock split can complicate dividend calculations. If a company pays a quarterly dividend, the dividend per share will be adjusted after the split. While the total dividend payout remains unchanged, the dividend per share will be proportionately reduced, which may confuse some investors.

The Psychological Effect of Stock Splits

Perception of Affordability

A lower share price post-split can create a perception of affordability among retail investors. Even though the intrinsic value of the investment remains the same, the reduced price per share can make it psychologically easier for investors to buy shares.

Influence on Investor Behavior

Research suggests that stock splits can influence investor behavior. Retail investors, in particular, may perceive a lower-priced stock as a better buying opportunity, leading to increased demand. This increased demand can, in turn, drive up the stock price post-split.

Potential for Media Attention

High-profile stock splits often attract significant media attention. This coverage can raise awareness of the stock among potential investors who were previously unaware of the company or hesitant to invest at higher prices. The increased visibility can lead to a short-term boost in demand for the stock.

The Long-term Impact of Stock Splits

Case Studies

Case Study: Apple Inc.

Apple's multiple stock splits over the years provide an excellent case study of the long-term impact of stock splits. Apple's stock splits in 1987, 2000, 2005, and 2014 were followed by periods of significant growth in both the stock price and the company's market capitalization. While the splits themselves did not directly cause this growth, they contributed to increased liquidity, broader investor participation, and positive market sentiment, which collectively supported Apple's long-term success.

Case Study: Tesla Inc.

Tesla's 5-for-1 stock split in 2020 came at a time of rapid growth for the company. Following the split, Tesla's stock continued to rise, driven by strong demand for electric vehicles and innovative advancements. The split made Tesla's shares more accessible to retail investors, contributing to its impressive market performance. Tesla's market capitalization grew significantly post-split, illustrating how stock splits can complement strong business fundamentals to enhance long-term shareholder value.

The Role of Stock Splits in Index Inclusion

Inclusion in major stock market indices, such as the S&P 500, can be influenced by stock splits. Companies with higher liquidity and broader ownership bases are often more attractive candidates for index inclusion. Being part of an index can lead to increased demand from index funds and ETFs, further boosting the stock's liquidity and valuation.

Conclusion

Stock splits are a fascinating aspect of the stock market, offering both potential benefits and risks. By understanding the mechanics of stock splits, the reasons behind them, and their implications, investors can make more informed decisions. While stock splits can improve liquidity and accessibility, they do not alter the fundamental value of a company. Therefore, investors should focus on the underlying business performance and long-term prospects rather than the split itself.

Ultimately, stock splits can be a useful tool for companies to manage their share price and attract a broader investor base. However, like any investment decision, they require careful consideration and analysis. By staying informed and approaching stock splits with a clear understanding of their purpose and impact, investors can navigate the complexities of the stock market with greater confidence.

This article has covered the key aspects of stock splits, including their definitions, examples, benefits, and drawbacks. With this knowledge, investors can better appreciate the nuances of stock splits and their role in the financial markets. By focusing on the fundamentals and considering the broader context, investors can leverage stock splits to enhance their investment strategies and achieve their financial goals.

 

The article was written by Michal.