How Does a Stock Split Work?
Publicly traded companies, including multi-billion dollar blue-chip stocks may do this. The firms grow in value due to acquisitions, new product launches, or share repurchases. At some point, the quoted market value of the stock becomes too expensive for investors to afford, which begins to influence the market liquidity as there are fewer and fewer people capable of buying a share. Suppose publicly traded Company XYZ announces a two-for-one stock split. Prior to the split, you own 100 shares priced at $80 each, for a total value of $8,000. After the split, your total investment value remains the same at $8,000, because the price of the stock is marked down by the divisor of the split, so an $80 stock becomes a $40 stock after the two-for-one split. Post-split, you would own 200 shares priced at $40 each, so the total investment would still be worth the same $8,000.
Types of Stock Splits
The most common types of stock splits are traditional stock splits, such as two-for-one, three-for-one, and three-for-two. In a two-for-one stock split, a shareholder receives two shares after the split for every share they owned prior to the split. In a three-for-one split, they receive three shares for every share, and in a three-for-two, they receive three shares for every two. One example is tech giant Apple. On Monday, August 31, 2020, Apple split its stock four-for-one, which means investors who owned one share of the stock now own four shares. Before the stock split, one share of Apple cost $499.23 (at closing on Friday, August 28, 2020). After the split, shares traded at about $127 each. While this split made the stock more accessible to investors, it was not the first time Apple split its stock. In fact, it was the fifth stock split since Apple’s IPO in 1980. In its last stock split in June 2014, Apple split its stock seven-for-one. Its per-share price was about $650, and after the split it was about $93 per share. Another example is Tesla, the electric car company. Tesla split its stock five-for-one on Monday, August 31, 2020. Prior to the split, a share of Tesla cost about $2,213 per share (at closing on Friday, August 28, 2020). After the split, the price was about $442. Some may wonder why a company wouldn’t split a stock, and one good example is Berkshire Hathaway class A. Over the years, Warren Buffett never split the stock. As of market close on August 28, 2020, one share of Berkshire Hathaway Class A stock traded at $327,431—far outside of the realm of affordability for the vast majority of investors in the United States and, indeed, the world. Buffett eventually created a special Class B share. This is an example of a dual-class structure. The B shares originally began trading at 1/30th of the Class A share value. (You could convert Class A shares into Class B shares but not the other way around.) Eventually, when Berkshire Hathaway acquired one of the largest railroads in the nation, Burlington Northern Santa Fe, it split the Class B shares fifty-for-one so that each Class B share is now an even smaller fraction of the Class A shares. As of market close on February 1, 2022, those Class B shares traded at $313.96, which is much more accessible for investors.
Pros and Cons of Stock Splits
Improves Liquidity
If a stock’s price rises into the hundreds of dollars per share, it tends to reduce the stock’s trading volume. Increasing the number of outstanding shares at a lower per-share price adds liquidity, which tends to narrow the spread between the bid and ask prices, enabling investors to get better prices when they trade.
Makes Portfolio Rebalancing Simpler
When each share price is lower, portfolio managers find it easier to sell shares in order to buy new ones. Each trade involves a smaller percentage of the portfolio.
Makes Selling Put Options Cheaper
Selling a put option can be very expensive for stocks trading at a high price. You may know that a put option gives the buyer the right to sell 100 shares of stock (referred to as a “lot”) at an agreed-upon price. The seller of the put must be prepared to purchase that stock lot. If a stock is trading at $1,000 per share, the put seller has to have $100,000 in cash on hand to fulfill their obligation. If a stock is trading at $20 per share, they have to have a more reasonable $2,000.
Often Increases Share Price
Perhaps the most compelling reason for a company to split its stock is that it tends to boost share prices. A Nasdaq study that analyzed stock splits by large-cap companies from 2012 to 2018 found that simply announcing a stock split increased the share price by an average of 2.5%. A stock that had split outperformed the market by an average of 4.8% over one year. Research by Dr. David Ikenberry, a professor of finance at the University of Colorado’s Leeds School of Business, indicated that price performance of stocks that had split outperformed the market by an average of 8% over one year and by an average of 12% over three years. Ikenberry’s papers were published in 1996 and 2003, and each one analyzed the performance of more than 1,000 stocks. An analysis by Tak Yan Leung of the City University of Hong Kong, Oliver M. Rui of China Europe International Business School, and Steven Shuye Wang of Renmin University of China looked at companies listed in Hong Kong and also found price appreciation post-split.
Could Increase Volatility
Stock splits could increase volatility in the market because of the new share price. More investors may decide to purchase the stock after it is more affordable, and that could increase the volatility of the stock. Many inexperienced investors mistakenly believe that stock splits are a good thing, because they tend to mistake correlation and causation. When a company is doing really well, a stock split is almost always inevitable, as book value and possibly dividends grow. If a person sees or hears about this pattern frequently enough, the two may become associated.
Not All Stock Splits Increase Share Price
Some stock splits occur when a company is in danger of having its stock delisted. These are known as “reverse stock splits.” While investors may see the per-share price go up after a reverse split, the stock might not grow in value, or it may take a while for it to recover. Novice investors who don’t know the difference could end up losing money in the market.
What Are Reverse Stock Splits?
Splits in which you get more shares than you previously had, but at a lower per-share price, are sometimes called “forward splits.” They are the opposite of reverse splits. A company typically executes a reverse stock split when its per-share price is in danger of going so low that the stock will be delisted, meaning it would no longer be able to trade on an exchange. A good example of a reverse stock split is the United States Oil Fund ETF (USO). In April 2020, it had a reverse stock split of 1-for-8. Its per-share price before the split was about $2 to $3. In the week following the reverse stock split, it was about $18 to $20 per share. So investors who had, say, $40 invested in 16 shares of USO at about $2.50 each, ended up with just two shares valued at about $20 each after the reverse split.
