If you follow the stock market news you often hear companies announcing stock splits. Many investors may not be familiar with what they are and how they work. So in this post we’ll explain what a stock split is, why a company might do this, and how it affects investors.
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So, What Are Stock Splits?
A stock split is a way for a company to increase liquidity in it’s shares by splitting them. Basically it’s just a way to split larger shares for smaller ones to make them more accessible. It does not affect the value of a company. It just divides it’s shares into smaller units.
Why Do Companies Do A Stock Split?
A common misconception is that stock splits are a way of raising money. This is not the case, the company share capital remains the same, they are just divided into smaller units.
A stock split is primarily done to make the stock more liquid. This means it is easier to trade as the price of a share is now lower, making them more in demand. They are particularly useful for very highly priced shares costing thousands of dollars.
Individual investors for instance may not have enough funds to purchase a stock costing thousands of dollars. By splitting the stock by several multiples, there are now more shares in issue but at a much lower price. Thus opening them up to more investors to purchase.
Stock splits can also be beneficial to management when it comes to staff remuneration. If the company rewards it’s employees with stock options, it can be more difficult if the value of shares is very high.
There may also be conditions for inclusion on certain stock market indices with regard to share prices. This is particularly true of a price-weighted index like the Dow 30.
How Does A Stock Split Work Exactly?
So when a company decides on a stock split, it’s existing stock will be divided down. Each company decides on an appropriate ratio. It could be 2-for-1, 10-for-1 or 100-for-1.
For example, in a 2-for-1 split, there will be 2 new shares for each current share. As the shares have multiplied by 2, the share price will divide by 2.
Stock splits do not affect the valuation of the company or a shareholders investment as the market capitalisation of the company remains the same. Multiply the current share price by the total number of shares in issue to get the market capitalisation.
For example, a company has a market capitalisation of $1,000,000. This consists of 1,000,000 shares of $1 value each. You own 100 shares in the company for a total value of $100.
The company announces a 2 for 1 stock split, meaning they issue two shares in place of every one old share. So there are now 2,000,000 shares in issue but as the stock has split at a ratio of 2:1, each share now has a value of $0.50.
If we calculate the market capitalisation again now ($0.50 x 2,000,000) we can see that it remains the same at $1,000,000.
Likewise your own personal $100 shareholding of 100 shares at $1 each has now become 200 shares worth $0.50 each. Which when multiplying together is still worth $100.
How Does A Stock Split Affect Investors?
A stock split has relatively little effect on existing investors. As seen in the above example, the value of your total shareholding will remain the same. You just own more shares at a lower share price.
They can make high priced shares appear at a more attractive price point to smaller investors. This may have small positive effect on the share price if lots more people can now afford to buy the stock. But there is no guarantee that this will happen.
Many popular mega cap tech stocks like Apple and Tesla have offered stock splits to keep their shares accessible for individuals to invest in. Fast growth of these types of companies often leads to their share prices rising quickly. Over many years of share price growth, their shares can cost several thousand dollars for a single share. This prices many individuals out of ownership.
Alphabet recently completed a 20-for-1 stock split. It’s share price of around $2,200 per share, the split left each share valued around $110 each. This is a much more affordable price for a lot of smaller investors that may previously have been unable to afford it.
One final point to note is that you may sometimes hear companies refer to a stock split as a special dividend. This is not to be confused with a regular cash dividend. It is just referring to the action of issuing additional shares to carry out the stock split. You do not receive any extra payment.
Conclusion
A stock split is just splitting a company’s shares down into smaller shares. After a stock split, there will be more shares in issue but at a lower price. It does not change the value of the company.
If you are an existing investor you receive a proportionate number of new shares to your old ones. For example, in a 10-for-1 split you would now own 10 shares for every one you held before. The overall value remains the same.
Stock splits are a way for a company to boost it’s liquidity. More shares trading at a lower price can encourage new investors to purchase the stock they may not have been able to afford before the split. This may have a positive affect on the company’s share price.
Other than that, stock splits do not really have much other effect on existing shareholders. They can make it a little easier for some aspects of company management.
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