What are stock splits and how do they impact investors?
City Index May 27, 2021 10:45 PM
Stock splits can create a flurry of activity in a listed company, both pre-split and post-split. Discover the mechanics of a stock split, the benefits for shareholders and how new investors react to the opportunity of buying shares at a lower price.
- What is a stock split?
- Why do companies split their shares?
- How a stock split works
- Are stock splits good for investors?
- Stock split vs reverse split
- Examples of a stock split
- How to know when a stock split will happen
- Trading stock splits
What is a stock split?
A stock split occurs when a company divides the existing shares of its stock into multiple new shares.
The number of shares outstanding will increase by a set multiple, but the total dollar value of the shares and the company’s market capitalisation stays the same as the pre-split value. The split doesn’t add any real value.
However, after the stock split takes effect, the share price and the market cap might change depending on the market’s reaction.
The most popular split ratios are 2-for-1 or 3-for-1 (2:1 or 3:1). The stockholder will own two or three shares after the split happens for every share held before the split.
Why do companies split their shares?
Companies split their shares to lower the cost of the stock, making each quoted share in the firm cheaper. In theory, this encourages more investors to hold individual shares in the firm.
A company might decide it’s time to act because the share price has become too high or that the price is out of sync with similar quoted firms in its sector. The stock split will also increase the stock’s liquidity, and more share trading might occur at a lower price.
The stock split is also good for the company if the market views the action as a positive move to encourage growth. A share price rise can occur when a stock splits because small investors may perceive the more affordable and buy the stock.
The stock split exercise also puts the firm in the spotlight, encouraging other new investors to look at the firm.
A psychological issue also comes into play. For instance, if the stock split is 3-for-1, would small investors prefer to own three shares at $500 each after the stock split or one share at the earlier price of $1,500?
Stock splits also signal that the company’s share price has increased significantly, encouraging the board to tame the rise. Investors might assume this growth trajectory will continue in the future even after the split.
Some companies have a history of stock splits. Apple has orchestrated five in its history as a firm quoted on the NASDAQ. The first on June 16, 1987, and the most recent on August 31, 2020.
How stock splits work
Stock splits work by automatically adjusting the price of shares in the market; a shareholder doesn’t have to do anything, although large shareholders could get asked to approve the measure.
It’s reasonable to assume that most investors would be more comfortable owning 100 shares of $10 stock instead of 10 shares of $100.
So, if a company’s share price has risen significantly, many quoted firms organise stock splits to reduce the share price to reach a more affordable trading range.
The company’s directors can decide to split the stock in several ways to make each share cheaper and more attractive to a broader base of private and institutional investors. For instance, a stock split might be 2-for-1, 3-for-1, 4-for-1, etc.
A 3-for-1 stock split means that the outstanding shares in the market will triple. There will now be three shares for every previously owned single share. The price of each share after the 3-for-1 stock split gets reduced by dividing the price by three.
The company’s market capitalisation stays the same after the split. Market capitalisation is the total number of shares outstanding times the price per share.
- If XYZ PLC has 10 million shares floated, and the shares are trading at $100, the market cap is 10 million shares x $100 = $1 billion
- If the board of directors at XYZ split the stock 2-for-1, the number of outstanding shares doubles to the new figure of 20 million
- The share price gets halved to $50, leaving the market cap unchanged at 20 million x $50 = $1 billion
Are stock splits good for investors?
Stock splits can be rewarding for investors for several reasons. One obvious benefit is selling a share more quickly and easily due to the increased liquidity while retaining part ownership.
For instance, if a shareholder had $1000 worth of stock but wants to sell $250 of their stock after the 2-for-1 split mentioned above, they’d sell five shares but still retain fifteen shares.
Before the stock split, they’d need to sell three shares and hold seven. Psychologically the shareholder might feel they still have a sizeable stake even if it’s the same holding in percentage terms.
A shareholder might diversify and balance their portfolio once a stock split occurs because the share price is lower. An investor only needs $50 to get a stake of one share in our XYZ example, not the previous $100. So, if they had perhaps $1000 to invest, they can put the $950 capital left into other firms.
The stock split creates discussion of the company in the financial and mainstream press, encouraging new investors to buy in at a more affordable price. In turn, this might cause demand and the share price to rise.
A confident board of directors often engineers stock splits with a clear plan and strategy, sending a positive message to analysts who might recommend the firm to investors. Such bold corporate moves can have a beneficial effect on the share price for existing shareholders.
After a stock split, existing shareholders might buy more stock. They know the market cap hasn’t altered, but they retain confidence in the firm and don’t want to miss the opportunity to buy more shares at the new (bargain) price.
Stock split vs reverse split
A stock split and a reverse split are opposites. The outstanding shares get increased with a stock split. Whereas, with a reverse split, the shares get decreased.
With a stock split, the split gets announced as 1-for-2, 1-for-3 etc. With a reverse split, it’s quoted as 2-for-1 or 3-for-1 etc.
A reverse stock split is sometimes considered an adverse corporate action, in contrast to the positive reaction a stock split typically receives.
Reverse stock splits often get judged as defensive. Investors can be suspicious that a company board is desperately trying to increase the share price.
When a corporation’s stock falls, it’s in danger of delisting from a stock exchange. If there’s a delisting, the stock becomes a penny stock. To avoid that fate, the company reduces the shares available to raise the share price.
The reverse stock split might not get the welcome the board hoped for; short sellers might target the company because they believe the new price is inflated and the firm overvalued.
Examples of stock splits
It’s helpful to look at some recent examples of stock splits to see how the process works.
In 2020 Tesla and Apple had stock splits that were generally well-received by their investors and the stock markets where the shares are listed.
Apple’s stock split
On August 31, 2020, Apple (AAPL) split its shares on a 4-for-1 basis to make its stock more accessible and affordable to more investors.
When the firm announced the split on August 20, the shares traded just above $380 per share. On August 28, the Friday before the event, the shares were trading at $408, suggesting that the market was bullish about the split announcement.
The board was perhaps aiming for a 4:1 split to value a single share at $100, with the stock split scheduled to occur on August 31, 2020.
Existing shareholders were given four more shares for each share they owned. So, an investor with 1000 shares of AAPL before the split would now own 4000 shares.
Apple’s outstanding shares would then increase from 3.4 to 13.6 billion shares. However, the market cap would stay largely unchanged at $2 trillion.
At the close of trade on August 31, the shares price was $129, up 3.4% on the day. Roughly nine months after the split, on May 20, 2021, Apple’s shares traded at $126, with a market cap of $2.10 trillion.
Tesla stock split
Tesla engineered a 5-for-1 stock split which came into effect on August 31, 2020, the same day as Apple’s stock split. But unlike Apple who experienced its fifth stock split, this was the first split for Tesla.
Tesla declared the rationale behind the split; ‘to make stock ownership more accessible to employees and investors’.
The stock split announcement came after Tesla’s share price had enjoyed spectacular growth. From August 2019 to August 2020, the share price surged by over 500%.
Tesla’s board announced the decision after the market closed on August 11. In after-hours trading, on the day, the share price rose by 6%.
Tesla’s stock closed 12.5% higher at $498.32 a share on Monday, August 31, and on May 20, 2021, the stock was trading at $580 per share with the market cap at $558.73 billion.
How to know when a stock split will happen
To know when a stock split will happen, you must pay attention to company news for any firm you’re interested in or have shares in and be ready for announcements. The firm is obliged to inform the stock exchanges and shareholders of the impending change.
When stock splits get announced by firms with wide-ranging popularity, such as Tesla and Apple, the mainstream financial press will undoubtedly cover the story in fine detail. You’ll get the scheduled date for the split, the stock split ratio, the current stock price and the target stock price once the split takes effect, based on the current price.
View our most recent news and analysis.
Stock splits can create lots of chatter and eventual excitement over a particular stock. The outcome is usually positive for a quoted firm.
Based on high-profile examples of Tesla and Apple, the stock price rises before the split once the event gets announced. Post-split, the share price enjoys a rally as more investors can buy-in at the lower price.
Trading stock splits with City Index
You can speculate on whether a share price will rise or fall following its stock split. All you have to do is:
- Open a City Index account, or log in if you’re already a customer
- Search for the company you want to trade in our award-winning platform
- Choose your position and size, and your stop and limit levels
- Place the trade
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