What are Stock Splits? – Wall Street Survivor

The Concept

Let’s say you bought a birthday cake for 10 people. However, more people showed up than expected, so you have to cut more than 10 slices. It is still the same amount of cake, no matter how many slices you cut it into. 

Same concept for a stock split. The board of directors will issue more shares of stock to shareholders without diluting their investment.  

For example, say you own 1 share worth $100. If the company opts for a 2-1 stock split, you will have 2 shares worth $50 each.

A stock split increases the number of shares outstanding, lowers the stock price, and the company’s market capitalization does not change. The most common stock split ratios are 2-1 and 3-1. 

Why do stock splits happen?

Companies decide to split their stock when the share price gets too high. That may seem counterintuitive, but it makes it seem more affordable for investors.

After the split, the stock price will be lower which will entice others to invest. Not everyone can afford a $300 stock, but if the price is $100, that makes it more attainable for more people.

Stock splits also create more trading liquidity for a company which is a good thing.

Another reason for a split is if other stocks in the sector are trading well below your price. The other stocks are not always a better value, but investors do make that assumption. 

Stock Split Affect

If you are a current shareholder of a company’s stock and they decide to split, it does not create an advantage for you.

It does not change your initial stake in the company; it will only increase the number of shares you own. Stock splits just try to reel in more outside investors.

A company will announce a stock split to lower the share price. The hope is that with a split, it will result in an increase in share price, but the market capitalization is not affected.

More people can buy, you see demand rising, and the price may go up.

When a split is announced, it is good news to hear for an investor. The announcement signals to the market that the company is growing and investors hope it continues to. 

Dividends paid by the company are usually adjusted proportionately to the stock split ratio, so the total amount received does not change. To learn more about dividend stocks, click here.

Exchange Traded Funds (ETF) are split the same way as a normal stock split.

Stock Split Studies

The question with stock splits is, are they beneficial to the stock or not? We will take a look at some studies done in the past to answer this question. 

One of the first studies on stock splits was done in the 1960s by economist Eugene Fama – founder of the efficient markets theory. Fama found that in the long run, the performance of a stock is no different after a split. 

David Ikenberry, Chairman of the Finance Department at the University of Illinois, did a study in 2003 examining the price effect of stock splits.

Ikenberry compared companies that split to similar companies that did not split. He chose 1000 companies from 1990 to 1997 and included 2-1, 3-1, and 4-1 splits.

The results showed that the split stocks on average outperformed the market by 8% the following year and 12% over the next three years. 

There have been more studies done in the past, but experts still have different opinions.

In the short term, a stock split might be bullish due to the increase in volatility. Looking down the line, a stock that split should eventually fall back in line with the market. 

Current Stock Splits 

Alphabet (GOOGL), which is the parent company of Google, announced back in February there will be a 20-1 stock split on July 15.

Google shares have returned around 150% over the past 5 years; compared to the S&P 500 return of 80%. Google has the growth momentum to support a stock split.

Google trades around $2,207 (based on the most recent close) a share and with the split, it would trade around $110 a share. This would make Google significantly more affordable for retail investors and ideally create a bullish run.

Amazon (AMZN) also announced they will be doing a 20-1 stock split effective June 3. This would be its first stock split since 1999.

Even though Amazon has had historic growth over the past twenty years, returns have underperformed the S&P 500 over the past three years.

They are hoping this split will bring new volume to the stock. Amazon shares would go from roughly $2,146 (most recent close) to around $107 – again more affordable for investors. 

Back in August of 2020, Apple (AAPL) conducted a 4-1 stock split. Their share price decreased about 75% after the split.

Before the 2020 split, Apple had a stock split four times since going public. Apple has had a history of short-term sell-offs post splits. Apple shares have lost an average of 5.6%, two weeks after a split. 

Source: Kensho

Tesla (TSLA) announced a 5-1 stock split in August of 2020. Their shares rose 80% over three weeks from just the announcement!

The pre-split price was around $2,213 and after the stock split, it was around $498.

The chart below shows the momentum after the announcement, but there is a drop once the split is effective. 

Source: MarketWatch

Conclusion

A reverse stock split is the opposite of a stock split. A company’s board will reduce the number of shares outstanding to create a higher price.

A reverse stock split does not change a company’s value.

The most common reverse stock splits are 1-5 and 1-10. A reverse stock split is also called a stock consolidation.

If a company issues a reverse stock split, it is usually a sign of distress.

Whether Stock Splits are a good thing or not just depends on the company.

A stock split is a sign that a company is excelling in terms of price and earnings growth.

If you are a believer in a company, a stock split is a golden opportunity to buy shares at a lower price. 

The most famous case of a company that will not split is Warren Buffet’s company, Berkshire Hathaway.

Their Class A stock currently trades at around $456,000 a share. Buffet says that he would rather focus on long-term gains, rather than temporary success.