What is a stock split?
Understanding Stock Splits
Definition:
A stock split is a strategic move by a company to increase the number of its outstanding shares, thereby enhancing the stock’s liquidity. This action does not alter the company’s overall value but redistributes it across a larger number of shares.
How It Works
Nature of Stock Split:
When a company undergoes a stock split, it issues additional shares to its current shareholders. This is done in proportion to the shares they already own. For instance, in a 2-for-1 split, for every share an investor owns, they receive an additional share. So, if you held 100 shares before the split, you’d have 200 shares afterward.
Price Adjustment:Â
Although the number of shares increases, the price of each share adjusts proportionally. Using the above example, if a share was priced at $100 before the split, it would be priced at $50 after the split. The total market value remains unchanged.
Reason for Stock Split
Companies often opt for stock splits when their share price becomes too high, potentially deterring new investors. By splitting the stock, they make individual shares more affordable, hoping to attract a broader base of investors.
Key Considerations
Market Capitalization:Â
This is calculated by multiplying the stock’s current price by the total number of outstanding shares. Even after a stock split, the company’s market capitalization remains unchanged. If a company’s shares were trading at $100 with 20 million shares outstanding (a market cap of $2 billion), after a 2-for-1 split with shares trading at $50, there would be 40 million shares outstanding, but the market cap would still be $2 billion.
Reverse Stock Splits:
This is the opposite of a traditional stock split. In a reverse stock split, the number of shares decreases, and the share price increases proportionally. Companies might opt for this if their share price is too low, risking delisting from stock exchanges that have minimum price requirements.
Advantages
Liquidity:Â
Stock splits can increase the liquidity of a company’s shares, making them more attractive to investors.
Affordability:Â
By reducing the price of individual shares, companies can make their stock more accessible to a broader range of investors.
Positive Signal:Â
A stock split can be perceived as a sign of a company’s growth and confidence in its future prospects.
Disadvantages
Costly Process:Â
Implementing a stock split can be expensive and requires adherence to regulatory laws.
No Fundamental Change:
A stock split doesn’t alter the fundamental value of a company. It’s akin to dividing a pizza into more slices; the total amount of pizza remains the same.
Real-World Examples:
a. The online retailer Amazon announced a 2-for-1 stock split in June 2014. An investor’s total investment would have been worth $30,000 if they had owned 100 shares of Amazon at the time of the split, valued at $300 a share. The investor’s ownership would increase to 200 shares following the stock split, but because the price per share would be automatically adjusted to $150, the overall worth of the investor’s investment would remain unchanged at $30,000.
b. Apple Inc. executed a 4-for-1 stock split in August 2020. Before the stock split, the trading price of each share was around $540. After the split, the price per share started at approximately $135. Therefore, if an investor had 1,000 Apple shares before the split, their ownership would quadruple to 4,000 shares afterwards, although the total value of their investment would remain the same.
Conclusion
The purpose of a stock split is often to make the stock more affordable and attractive to a broader range of investors, potentially increasing the liquidity and marketability of the shares. It’s important to note that while the number of shares increases and the price per share decreases, the market capitalization of the company (the total value of all shares) remains unchanged.
As an investor, understanding the mechanics and implications of stock splits can help you make informed decisions in the stock market.