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What is a stock split?
The world’s biggest companies have traditionally split their stocks and increased the number of outstanding shares. Find out what this means for your shares and investments.
QUOTE
"A stock split is simply a cosmetic change in the stock’s price."
A forward stock split is an increase in company shares and a reduction in the share price. It does not affect the overall market capitalisation. So why do so many major companies engage in stock splits?
Big ideas
- A stock split enhances the liquidity of shares, and the lower price is often more appealing to investors. But stock splits do not change any company fundamentals or affect market capitalisation.
- Stock splits are mainly a bullish sign, especially for blue chip companies, which can benefit from renewed investor interest.
- Despite a lot of criticism about stock splits being merely cosmetic, companies that undergo stock splits tend to outperform the market.
What are stock splits?
DEFINITION & EXAMPLE
A stock split occurs when a company increases the total amount of available shares.
If a company has 100,000 shares valued at $6 each, a 2:1 stock split would mean there are now 200,000 shares at $3 each.
The stock split ratio of 2:1 means a doubling of the total number of shares and a halving of the price of each share.
If a company has 100,000 shares valued at $6 each, a 2:1 stock split would mean there are now 200,000 shares at $3 each.
The stock split ratio of 2:1 means a doubling of the total number of shares and a halving of the price of each share.
This increases the liquidity and ease of trading but does not change the company’s value, as the total share value would remain the same. In the above example, the value is $600,000 before and after the stock split. The market capitalisation remains the same.
Stock splits can occur in any specific ratio but most commonly occur at 2:1 or 3:1. This means that shareholders will hold two or three times the amount of shares after the stock split. And the price per share will also go down accordingly by a factor of two or three.
Stock splits can occur in any specific ratio but most commonly occur at 2:1 or 3:1. This means that shareholders will hold two or three times the amount of shares after the stock split. And the price per share will also go down accordingly by a factor of two or three.
Two-for-one stock split
The same applies to the dividends of split shares. The dividends per share will go down in the total dollar amount, though expressed as a percentage, it will remain the same. 10% of a share valued at $50 is the same as 10% of two shares at $25 each. Each returns $5 for a $50 investment.
Why do companies split stock?
Company executives will decide to split the stock to make the price more affordable for everyday investors. The lower trading price makes it easier for investors to purchase the stock. A stock split increases liquidity because there will be more shares to buy and sell available.
Admittedly, with the rise of fractional shares pioneered by Trading 212 in the UK, the appeal of a stock split is not what it once was.
A large psychological element is involved in stock splits as opposed to material benefits. The majority of investors are more comfortable purchasing 100 shares at $10 than 1 share at $1,000. The dollar amount is the same, but it feels like they have gotten “more”. People often assume that lower-priced shares are a better buy (i.e. buy low and sell high).
Splitting a stock can be a costly and burdensome procedure, requiring legal oversight and accounting professionals to ensure everything is up to speed. The company is paying a relatively large sum for a manoeuvre that has no direct impact on its market capitalisation.
Disclaimer: historical price charts used in this article are for educational purposes only. Past performance is not a guarantee of future results.
Admittedly, with the rise of fractional shares pioneered by Trading 212 in the UK, the appeal of a stock split is not what it once was.
A large psychological element is involved in stock splits as opposed to material benefits. The majority of investors are more comfortable purchasing 100 shares at $10 than 1 share at $1,000. The dollar amount is the same, but it feels like they have gotten “more”. People often assume that lower-priced shares are a better buy (i.e. buy low and sell high).
Splitting a stock can be a costly and burdensome procedure, requiring legal oversight and accounting professionals to ensure everything is up to speed. The company is paying a relatively large sum for a manoeuvre that has no direct impact on its market capitalisation.
Disclaimer: historical price charts used in this article are for educational purposes only. Past performance is not a guarantee of future results.
Average performance of companies that have announced splits since 1980
Still, companies that undergo stock splits tend to outperform the market, at least for the following 12 months, according to research from Bank of America. The above chart is tilted towards stocks in the technology, discretionary, healthcare, and financial sectors. Up to 30% of companies that undergo stock splits will see negative returns within a year.
In other words, stock splits have their advantages and disadvantages. Let's run over some of the pros and cons of stock splits.
In other words, stock splits have their advantages and disadvantages. Let's run over some of the pros and cons of stock splits.
Pros of a stock split
The main advantages of stock splits are liquidity and psychological appeal. It is helpful for investors to own 100 shares, known as a “board lot” on exchanges. This is a standardised trading unit on exchanges. It is also more reassuring and flexible for investors to own large share amounts than one high-valued share.
Blue Chip companies have track records of stock splits when the shares reach a certain price, and they may split the stock over and over and over, across decades. It can be a continual bullish sign for certain types of long-term investors.
Stock splits can lead to renewed investor interest and usually do have a positive effect on the stock price. Some investors look at stock splits as a sign that the executives have plans for future growth. In sum, the pros of a stock split include:
✔️ Increase liquidity
✔️ Renewed investor interest
✔️ Bullish sign
✔️ Often does result in a share price increase
Blue Chip companies have track records of stock splits when the shares reach a certain price, and they may split the stock over and over and over, across decades. It can be a continual bullish sign for certain types of long-term investors.
Stock splits can lead to renewed investor interest and usually do have a positive effect on the stock price. Some investors look at stock splits as a sign that the executives have plans for future growth. In sum, the pros of a stock split include:
✔️ Increase liquidity
✔️ Renewed investor interest
✔️ Bullish sign
✔️ Often does result in a share price increase
Cons of a stock split
But stock splits are not to be taken lightly and certainly not conducted on a whim. As previously stated, they can be quite expensive to undertake. There are considerable regulatory laws to be adhered to, and specialist lawyers and accountants will have to be consulted. It costs a lot of money to see no direct benefits in business performance!
No value is created with a stock split, and some view it as a pointless procedure done to increase hype and little else. It can be compared to cutting a pizza into more slices. If a pizza tastes good or bad, it doesn't matter how it is sliced up.
Companies that want to attract a certain 'style of investor' might not be interested in stock splits. A high share price can be appealing to high-net-worth individuals. Some executives may also want to own a majority of shares instead of increasing the total number of investors.
Finally, there are minimum compliance requirements for many exchanges. If a share drops below $1 for 30 consecutive days on a public exchange like the NASDAQ, it will be issued with a warning. Ultimately, the share could even be delisted.
In sum, the cons of a stock split include:
❌ High cost
❌ Extensive legal and regulatory requirements
❌ Might put off some investors
❌ Price might go too low
❌ No value generated, just splitting figures
❌ May be a time limit on the sale of stock split shares
No value is created with a stock split, and some view it as a pointless procedure done to increase hype and little else. It can be compared to cutting a pizza into more slices. If a pizza tastes good or bad, it doesn't matter how it is sliced up.
Companies that want to attract a certain 'style of investor' might not be interested in stock splits. A high share price can be appealing to high-net-worth individuals. Some executives may also want to own a majority of shares instead of increasing the total number of investors.
Finally, there are minimum compliance requirements for many exchanges. If a share drops below $1 for 30 consecutive days on a public exchange like the NASDAQ, it will be issued with a warning. Ultimately, the share could even be delisted.
In sum, the cons of a stock split include:
❌ High cost
❌ Extensive legal and regulatory requirements
❌ Might put off some investors
❌ Price might go too low
❌ No value generated, just splitting figures
❌ May be a time limit on the sale of stock split shares
Stock split example 1: Amazon
In recent years, many major companies have taken to stock splits. This includes mega firms like Amazon, Tesla, Google, Apple, and Netflix.
While the stock split ratio is usually 2:1 or 3:1 ratios, Amazon went through a 20:1 stock split with a $10 billion buyback in 2022. This is highly unusual, though Google also engaged in a 20:1 stock split in the same year. This is the fourth stock split undertaken since Amazon’s IPO in 1997.
While the stock split ratio is usually 2:1 or 3:1 ratios, Amazon went through a 20:1 stock split with a $10 billion buyback in 2022. This is highly unusual, though Google also engaged in a 20:1 stock split in the same year. This is the fourth stock split undertaken since Amazon’s IPO in 1997.
After the announcement, Amazon stock rose by 6%. The split took the price of the company's shares from about $2,800 to $140. However, Amazon had a rough year in 2022, being among the worst big tech performers with a poor start. A spokesperson for Amazon stated the reasons for the split, saying the split would give employees more flexibility in managing their equity in the company as well as to make the share price more accessible.
Stock split example 2: Tesla
On August 24, 2022, TSLA stock traded at $891. The next morning, shares were priced at roughly $302. The stock split announcement came in March of the same year.
What’s interesting about Tesla’s stock split is that it is the second stock split in two years. In August 2020, the company underwent a 5:1 stock split. Following the 2020 stock split announcement, the share price rose by 60%. Stock splits usually result in an increase in price from the announcement date to the date of the split before going back to the loosely the same price, accounting for the fact that there are more shares.
What’s interesting about Tesla’s stock split is that it is the second stock split in two years. In August 2020, the company underwent a 5:1 stock split. Following the 2020 stock split announcement, the share price rose by 60%. Stock splits usually result in an increase in price from the announcement date to the date of the split before going back to the loosely the same price, accounting for the fact that there are more shares.
Tesla Share Performance
Source: Trading 212. Past performance doesn’t guarantee future results.Speaking on the 2020 Tesla stock split, an SEC statement from the company indicated why it was being done. The EV company said it believes the stock split would help give employees more flexibility in how to manage the common stock they own, which would serve to maximise stockholder value and also make the common stock more accessible to retail shareholders.
Warren Buffet is against stock splits
While we have seen a resurgence in the popularity of stock splits in recent years, some established companies do not split their stocks. A prominent example is Berkshire Hathaway, headed by Warren Buffet.
The primary reason that Buffet has cited as being against stock splits is that he wants high-quality, long-term investors. This is as opposed to short-term traders who will pull out regularly or liquidate easily.
The primary reason that Buffet has cited as being against stock splits is that he wants high-quality, long-term investors. This is as opposed to short-term traders who will pull out regularly or liquidate easily.
QUOTE
“We want to attract shareholders who are as investment-oriented as we can possibly obtain, with long-term horizons.”
Buffet stated that he saw no point in having a cheaper stock that did not add any intrinsic value to investors. He also stated that it would attract shareholders that did not have the same level of sophistication or market knowledge.
While this might sound harsh, remember that shareholders have the right to vote in a company. It has become very common now for people to invest in stocks without attending the annual general meeting or participating in company affairs in a meaningful way. The quality of shareholders can be a big consideration for moguls or a group of motivated individuals with specific aims and objectives.
While this might sound harsh, remember that shareholders have the right to vote in a company. It has become very common now for people to invest in stocks without attending the annual general meeting or participating in company affairs in a meaningful way. The quality of shareholders can be a big consideration for moguls or a group of motivated individuals with specific aims and objectives.
Class A Berkshire Hathaway price percentage change
Source: TradingView. Past performance doesn’t guarantee future results.At the time of writing, the price of a Class A Berkshire Hathaway share is $487,000, well out of the reach of retail investors. The company does not pay any dividends to shareholders and reinvests the money. It is also sitting on over $100 billion in cash.
In short, Buffet wants investors that are aligned with the company and invested for the long term. A stock split tends to increase the rate at which shares are sold and swapped.
In short, Buffet wants investors that are aligned with the company and invested for the long term. A stock split tends to increase the rate at which shares are sold and swapped.
How a stock split affects traders
A stock split increases the number of shares and reduces the price. As such, this will typically increase the total trade volume on exchanges. The higher the price, the harder it is to find a market. To use the same concept in real estate, a lot more 2-bedroom flats are sold than multi-million dollar mansions.
There are far more individual traders than institutional traders, and only institutions will have the funds for super high-priced shares. There are also increased regulations surrounding big-ticket trades, and for leveraged positions, the collateral must be enormous to facilitate such trades.
No matter what the trade, stock splits are adjusted so that open positions are not adversely affected. Take, for example, a call option with a strike price of $100. A call option is the right to purchase a share at a specific price.
If a share priced at $90 underwent a stock split to $30 (a 3:1 stock split), then your call option would be an expensive waste. What happens is that your total number of shares is increased by a factor of three, so you would break even (for $90).
For short selling, there is a similar scenario only in reverse. Short selling is when you sell a share at a specific price. You might have sold a specific amount of shares for $150. A stock split could reduce the price to $50, meaning you make $100 on every share. But you will simply have to provide three times as many shares for the order, rendering it even anyway (for $150).
In short, a stock split does not affect open positions on trading exchanges. However, the increase in shares at a lower price can increase the volatility and volume of the shares, opening up the market.
There are far more individual traders than institutional traders, and only institutions will have the funds for super high-priced shares. There are also increased regulations surrounding big-ticket trades, and for leveraged positions, the collateral must be enormous to facilitate such trades.
No matter what the trade, stock splits are adjusted so that open positions are not adversely affected. Take, for example, a call option with a strike price of $100. A call option is the right to purchase a share at a specific price.
If a share priced at $90 underwent a stock split to $30 (a 3:1 stock split), then your call option would be an expensive waste. What happens is that your total number of shares is increased by a factor of three, so you would break even (for $90).
For short selling, there is a similar scenario only in reverse. Short selling is when you sell a share at a specific price. You might have sold a specific amount of shares for $150. A stock split could reduce the price to $50, meaning you make $100 on every share. But you will simply have to provide three times as many shares for the order, rendering it even anyway (for $150).
In short, a stock split does not affect open positions on trading exchanges. However, the increase in shares at a lower price can increase the volatility and volume of the shares, opening up the market.
What is the difference between stock splits vs reverse stock splits?
DEFINITION
A reverse stock split is the opposite of a typical or forward stock split. The total amount of shares is reduced, and each share increases in value.
This means that if you have two shares worth $500 each, you could now have one share worth $1,000 at a 2:1 reverse stock split ratio. Reverse stock splits are much rarer than forward stock splits. Again, the market capitalisation of the company remains the same. There is less incentive for a company to engage in a reverse stock split because the share price should rise in time naturally if the company is efficient.
Reverse stock splits make sense if a low-priced share needs to be increased to the minimum needed for exchanges (usually $1). Moreover, shares that trade at less than $5 are viewed as penny stocks and have a generally poorer reputation.
Another instance where a reverse stock split makes sense is when a company is engaging in spin-off enterprises and wants to maintain its existing share price. Hilton Enterprises did this in 2017 with a 3:1 reverse stock split. While a reverse stock split is usually a bearish sign, there are some instances (as was the case with Hilton) where it is the correct decision.
Reverse stock splits make sense if a low-priced share needs to be increased to the minimum needed for exchanges (usually $1). Moreover, shares that trade at less than $5 are viewed as penny stocks and have a generally poorer reputation.
Another instance where a reverse stock split makes sense is when a company is engaging in spin-off enterprises and wants to maintain its existing share price. Hilton Enterprises did this in 2017 with a 3:1 reverse stock split. While a reverse stock split is usually a bearish sign, there are some instances (as was the case with Hilton) where it is the correct decision.
Recap
Why do companies do stock splits? Stock splits increase the number of shares and decrease the price of each share at a specific stock split ratio - 2:1, 3:1, or even 20:1 and higher.
Stock splits increase liquidity and ensures that retail investors have access to the market. In recent times, major companies like Tesla, Apple, Google, and Amazon have engaged in stock splits. Stock splits are expensive and do not affect market capitalisation in any way.
Stock splits increase liquidity and ensures that retail investors have access to the market. In recent times, major companies like Tesla, Apple, Google, and Amazon have engaged in stock splits. Stock splits are expensive and do not affect market capitalisation in any way.
Stock split vs Reverse stock split
Reverse stock splits are less common, but they also have their place, in certain instances, to increase the share price and decrease liquidity.
FAQ
Q: What is a stock split?
A stock split occurs when a company increases the total amount of shares, usually by a factor of two or three. The price of each share will then go down by a factor of two or three accordingly.
Stock splits are used to reduce the price of each share so that certain investors are more comfortable making a purchase. It frees up liquidity for a company and typically leads to increased investment. However, it does not generate any intrinsic value or have any direct financial benefit.
Stock splits are used to reduce the price of each share so that certain investors are more comfortable making a purchase. It frees up liquidity for a company and typically leads to increased investment. However, it does not generate any intrinsic value or have any direct financial benefit.
Q: Will a stock split affect my taxes?
Stock splits do not really affect your taxes. The reason is that you still have the same dollar amount and are taxed when you sell your shares. However, you still have to calculate the cost basis for each specific share against the profits made from a sale. You are taxed on the profits made on each share, including dividends.
When a stock split occurs, the new stock is regarded as having the same holding period as the original share. Long-term capital gains usually have a better rate than short-term capital gains. Long-term is more than one year.
The taxes you pay depend on the type of investment and your individual tax circumstances, such as your income level and tax bracket, and may be subject to change.
When a stock split occurs, the new stock is regarded as having the same holding period as the original share. Long-term capital gains usually have a better rate than short-term capital gains. Long-term is more than one year.
The taxes you pay depend on the type of investment and your individual tax circumstances, such as your income level and tax bracket, and may be subject to change.
Q: Why would a company do a stock split?
Because in business, liquidity can be as important as profitability. A stock split makes it easier to trade and should see increased investment. Another related reason would be to control the share price, which is more appealing to investors. A company can also offer bonus shares via a stock split instead of dividends to keep shareholders satisfied. This is an alternative way to generate liquidity for the company.
Q: What are the downsides of a stock split?
The primary downsides of a stock split are the cost and the administrative burden for no significant commercial value. It simply makes the share price more accessible and increases liquidity. When the stock has split, the shares usually come back to equilibrium, the same price they were before the split, accounting for the increased numbers of shares.
Q: Do companies do well after stock splits?
Generally, companies tend to outperform the market for up to a year after a stock split. However, this is dependent on the specific circumstances. Gains in tech stocks have been between 25% - 38% for the following year after the announcement of a split. Of course, nothing is guaranteed. At the time of this writing, TSLA trades at $201, less than its $300 price after its 2022 stock split.
- Market Cap (Market Capitalisation): The total value of a company’s outstanding shares, calculated by multiplying the share price by the number of shares. It helps investors compare the relative size of different companies.
- Blue Chip Companies: Large, well-established, and financially stable companies with a history of reliable performance.
- Liquidity: The ease with which an asset can be bought or sold without significantly affecting its price.
- Dividends: Payments made by a company to its shareholders, usually from its profits.
- Spin-Off Enterprises: A business strategy where a company separates a division or subsidiary into an independent entity, often to improve focus or unlock shareholder value.
