What Is a Stock Split and Why Does It Happen?
Stock splits are unique and often anticipated events by market watchers, traders, and investors alike. This rare and substantial event can be a game changer for the market and the companies involved. So what is a stock split, what does a stock split mean to an investor and why do companies split stocks?
What Is a Stock Split?
As the name entails, stock splits refer to when companies split their stocks by increasing the number of their outstanding shares. However, although the number of shares outstanding increases, the value of the company remains the same. To better understand this concept, one could refer to the famous saying by Yankees legend, Yogi Berra, who said “you better cut my pizza into four slices because I’m not hungry enough to eat six.” Even though the pizza is cut into more slices, its value as a whole pie remains the same. Accordingly, following the same logic, a company's market cap would remain the same as it was before the split. (Source:Investopedia)
Why Do Companies Split their Stock?
So why would a company want to split its stock if its value is kept unchanged? Essentially, companies split stocks in order to make them more liquid. Further, stock splits don’t change the stocks fundamentally, instead, they make it easier and more accessible for shareholders to buy. This is because while the value of the company remains the same, a company’s existing shares are broken into multiple new shares without affecting the company's market capitalization or shareholders' equity all while making the price of the share cheaper.
How Does a Stock Split Affect Traders & Investors?
If you’re an investor, trader, or simply an inquisitive reader you might at one point find yourself asking “what is the point of a stock split and what are the pros and cons of splitting stocks?”
First and foremost, when a company splits its stock, it intends to increase its liquidity, which means that it would be easier and also cheaper for investors and traders to buy or sell the stock in question. Traders also get to receive additional shares for every share they own after stock splits. For example, if you’re a trader who owns $100 worth of a company’s share, and a 2-for-1 split occurs, then you’ll get ownership of two shares worth $50 each. In other words, you’ll get to buy stocks for a cheaper price while also owning more stocks than you originally did (for the original price you paid). Moreover, stock splits are deemed a generally good indicator of a healthy company because it usually means that the company splitting its stock is a good investment. (Source:CNBC)
What Are the Disadvantages of a Stock Split?
On the other side of the coin, stock splits are not black or white and do have some drawbacks of their own. One perhaps more obvious disadvantage of stock splits is that while stock splits give investors more shares of the company as well as make the shares more affordable, it also means that your existing share would cost less. In addition, stock splits can also increase market volatility. This is because stock splits bring forth new stock prices, which means that more investors may tend to purchase the split stock which, in turn, can increase volatility. This aspect may be viewed by some as a plus, while to others it might seem like a burden.
What Are Reverse Stock Splits?
In addition to the aforementioned potential drawbacks, it is important to note that stock splits don’t always occur when companies are healthy or worthy of investing. In some cases like in “reverse stock splits,” companies do it in order to avoid having their stock delisted. After a reverse split, some investors may see the stock price rise, but the stock may not increase in value, or it may take a long time to recover.
Stock Split Ratios
Stock splits can happen in different ratios. However, two-to-one and three-to-one ratios are the most common split ratios. Bear in mind that the number of shares each stockholder holds before the split will determine the number of shares they will hold after the split.
Recent Notable Stock Splits
Some of the recent stock splits over 2022 are Alphabet (GOOG), Amazon (AMZN), and Tesla (TSLA). As mentioned above, stock splits do not always solicit a rise in the stock price. Take for example tech giant Alphabet which split its stock on July 15th, 2022 by a 20-for-1 ratio. After the split came to fruition, the company’s shares went through a price rollercoaster, perhaps driven by higher interest rates and inflation. This may be because investors usually tend to shy away from tech stocks and opt for more inflation-proof safe havens. In the first 12 days after the split, the company’s share rose by 2%. However, since the stock split and the time of the writing, Alphabet has fallen by 15%.
As for the other mentioned companies, as of the time of the writing, Amazon dropped 23% since it approved its 20-for-1 split on March 9th, 2022, and EV maker Tesla tumbled by 33% following its approval of the 3-for-1 stock split on August 4th, 2022.
Conclusion
To sum it up, the stock split can be a significant event for the market, the company splitting the stock, and investors. However, like everything else, this event is not black or white and has its own pros and cons. It’s a trader’s choice whether or not they would want to buy or sell a split stock.
