What Is a Stock Split?
Companies like to play with the price of their stocks. Here’s why and what you should know.
Editors note: the following is a version of an article originally published in March 10.
On Wednesday, March 28, Tesla TSLA announced plans to propose a stock split during its annual meeting in October 2022. If approved, it would mark the company’s second stock split within three years. However, Tesla didn't specify what the planned split would be or when it would take place.
Tesla's last stock split was a 5-1 split in August 2020, when investors received an additional four shares for each one that they owned. A number of big-name technology and consumer companies have announced stock splits recently. At the beginning of March, Amazon.com AMZN announced a 20-1 split. In February, Alphabet GOOGL , the parent company of Google, also announced plans for a 20-1 stock split. Back in July 2021, Nvidia NVDA had a 4-1 split.
What happens when a stock splits?
Simply put, a stock split is exactly what it sounds like. One share gets divided, or split, into multiple shares. Don’t worry, though. The value of your holdings is the same, just in smaller chunks.
Think about it like a dark chocolate bar. Your one big dark chocolate bar is broken down into multiple bite-size pieces. You still have the same amount of chocolate, just in smaller segments.
Similarly, in a stock split, it is very important to remember that the price of the share also is reduced. For example, if a company board announces a 2-for-1 split, then you get one extra share for each share you own--but the share price will be halved. In this example of a 2-for-1 split, if you had one share of Company X at $10 per share, you now have two shares of Company X at $5 per share.
This does not mean that the stock has become cheaper. The fundamentals of the company and the stock price have not changed. Sticking with the dark chocolate bar analogy, after breaking the bar into smaller bits, you have smaller bits of dark chocolate, not more chocolate overall.
Why does a company split stock? Why do companies announce stock splits? Stock splits are a way for companies to increase their overall liquidity.
Liquidity means the ease with which investors can buy or sell shares on a stock exchange. The less each share costs, the less money is needed by even the smallest investor to buy or sell the stock.
In most cases, stock splits are undertaken by companies when the share price has gone up significantly, particularly in relation to a company’s stock market peers. If the share price becomes more affordable for smaller investors, it can reasonably be assumed that more investors will participate, and so the overall liquidity of the stock would increase as well.
But remember this with stock splits: Though the number of outstanding shares changes, and though the price of each share changes, the company's overall market capitalization stays the same. The value of the company doesn’t increase when a split occurs, therefore the value of your stocks, your shares, doesn’t change, either.
Take Alphabet for example. It closed Tuesday, Feb. 1, at $2,572.88. Many investors (myself included) would not be able to invest in Alphabet, because I do not have $2,500-odd to invest in one share of one company. Now if the stock split were to happen as of Tuesday’s close, the cost of each share would go from $2,572.88 to $128.64, and each existing holder would get 19 additional shares for every share they own. A stock price of $128-odd would be much more manageable, both for me and for many others.
This is especially true now with more and more investors having access to low-cost trading platforms. Buying and selling stocks is now easier than ever, and for many investors these recent splits might be an entry point into companies they have long admired.
All this being said, these recent high-profile splits seem superfluous given that most brokerage platforms now enable trading in fractional shares. Perhaps the psychology of owning at least one whole share is at play in the companies’ decisions.
“When we look at a company like Apple and strictly observe the value of an investment immediately after a stock split, there really isn’t a discernable pattern in the change in wealth. What is noticeable is the trading volume of the stock which might be attributed to news flow. All this said, for long-term investors in a stock, a stock split (or reverse split) really doesn’t affect the fundamental value of the company or the wealth in your pocket,” points out Morningstar Canada’s director of Investment Research Ian Tam.
Does the Company Change? Not at all. Stock splits do not alter the fundamentals of the company in any way, apart from the short-term price increases we described earlier. There's no harm done in this regard if the stock doesn't split either.
What is a reverse stock split? The opposite of a stock split, which is technically called a forward stock split, is a reverse stock split.
In the case of reverse stock splits, the company divides the number of shares that investors own, rather than multiplying them. As a result, the price of the shares increases.
For instance, if you own 10 shares of Company X at $10 per share, and the company announces a 1-for-2 reverse stock split, you end up owning five shares of Company X at $20 per share. Usually, reverse stock splits are announced by companies that have low share prices and want to increase them--often to avoid being delisted.
Is a stock split good?
You may think that reverse stock splits are bad news for the company, but this is not always the case. One of the most famous examples of reverse stock splits is Citigroup C. Its share price declined to under $10 during the 2008 global financial crisis and stayed there, so in 2011 the Citigroup board decided to do a reverse split of 1-for-10. The split took the price from $4.50 per share to $45 per share. The company--and the stock--survived and is now trading at around $65 per share.
See, just math!