Defining a stock split
The board of directors of a firm may decide to split its shares, which increases the number of outstanding shares. This is accomplished by multiplying each share, hence lowering the stock price. However, a stock split has no impact on the company's market capitalization. Similar to how a $100 bill's worth doesn't change when it is swapped for two $50 bills, this amount stays the same. Consequently, each owner obtains an additional share for each share they now own in a 2-for-1 stock split, but the value of each share is decreased by 50%. As a result, the original value of one share before the split is now equal to two shares.
Let's imagine that stock A has 10 million shares issued and trades at $40. It now has a market value of $400 million ($40 multiplied by 10 million shares). A 2-for-1 stock split is then implemented by the corporation. Shareholders will get an additional share for every share they currently possess. For every share they previously owned, they now have two shares, but the stock price has been reduced by 50%, from $40 to $20. While the number of outstanding shares doubles to 20 million and the stock price drops by 50% to $20, the market capitalization remains unchanged at $400 million. The company's true worth hasn't altered at all.
So, what happens?
Investors don't become rich from stock splits. In actuality, a stock split has no impact on the company's market capitalization, which is determined by multiplying the number of shares outstanding by the share price. The share price will decline proportionately as the number of shares rises.
After a 2-for-1 split, a stock that formerly traded at $100 will now be worth $50. Although you have more shares, they are all worth less. The outcome is essentially a draw, and your investment's worth will remain unchanged.
Stock split announcements, however, typically elicit a favorable response from investors, in part because they show that a company's board intends to draw in investors by lowering the price and expanding the number of shares available. As a result, if the stock keeps rising, your portfolio could gain handsomely. According to studies, stocks that have split have gone on to outperform the general market in the year immediately after the split and the years that follow.
Why do companies split their stock?
The board of a firm may opt to split its shares if its share price rises to a minimal level that would unnerve some investors or exceeds that of other companies in the same industry. Even when the company's fundamental value has not altered, a stock split can make the shares appear more reasonable. Additionally, it may improve the stock's liquidity.
Even while there can be a decline in share price just after the stock split, it's possible that a stock split will also lead to a rise in share price. This is due to the possibility that novice investors would view the stock as more accessible and purchase it. As a result, the stock is in more demand, which raises prices. A stock split informs the market that the company's share price has been rising, and as a result, people may think that this growth will continue in the future, which is another potential explanation for the price increase. These increase prices and demand even more.
To make its shares more available to more investors, Apple Inc. divided its shares seven for one in June 2014. The opening price of each share was around $649.88 just before the split. At market opening following the split, the price per share was $92.70 (648.90 / 7).
Additionally, existing shareholders received six extra shares for each share they already owned before the stock split. A shareholder who held 1,000 shares of Apple before the stock split would now have 7,000 shares. The number of Apple shares in circulation climbed from 861 million to 6 billion. The company's market value, though, stayed essentially the same at $556 billion. The price rose to a peak of $95.05 the day after the stock split, reflecting the higher demand brought on by the reduced stock price.
Common stock splits
Stock splits come in a variety of shapes and sizes. Three stock splits are most frequently used: 2-for-1, 3-for-2, and 3-for-1. Divide the prior stock price by the split ratio to get the new stock price quickly. Divide $40 by two using the previous example to arrive at the new trade price of $20. We would follow the same procedure if a stock underwent a 3-for-2 split: 40/(3/2) = 40/1.5 = $26.67.
Reverse stock splits are typically carried out when a company's share price drops precipitously.
A reverse stock split can also be implemented by businesses. In a 1-for-10 split, you receive one share for every 10 shares you currently possess. In the example below, we show precisely how a split affects the number of shares, share price, and market capitalization of the company that is splitting.
There are a number of reasons why businesses think about splitting their stock. It starts with psychology. Some investors may feel that a stock's price is too high for them to purchase it when it rises in value, while smaller investors may feel that it is expensive. The stock price drops to a more desirable level after being split. The stock's perceived value may alter due to the decreased stock price, luring in new investors despite the fact that the stock's true value remains unchanged. Additionally, if the stock price improves, existing shareholders will have more stock to trade since they will feel as though they have more shares than they had before the stock was split.
To boost a stock's liquidity is a different motive, one that is perhaps more reasonable. This rises as more shares of the stock are in circulation. Large bid/ask spreads are possible for stocks that trade above several hundred dollars per share. Warren Buffett's Berkshire Hathaway (BRK.A), which has never split its shares, is a prime illustration. Its bid/ask spread is frequently greater than $100. The class A shares were worth more than $257,000 as of March 2020.
The financial theory does not support any of these justifications or probable outcomes. Splits are completely pointless, a finance expert will surely tell you, yet businesses continue to use them. Splits are a fantastic example of how business decisions and investor behavior don't always follow the rules of finance. This very reality has given rise to behavioral finance, a broad and relatively recent field of financial study.
Defining a reverse stock split
A reverse split is yet another kind of stock split. Companies that want to raise their pricing and have low share prices frequently utilize this technique. A corporation might take this action to boost its credibility in the market or because it fears that its shares will be delisted. If a stock's price per share drops below a specific level, several stock exchanges will delist it.
In a reverse one-for-five split, for instance, 10 million shares that were previously outstanding at $0.50 cents each would become 2 million shares that were previously outstanding at $2.50 apiece. The company is still worth $5 million in both scenarios.
In an effort to lower share volatility and deter speculative trading, Citigroup reversed split its shares 10 for 1 in May 2011. Following the reverse split, the share price rose from $4.52 to $45.12 per share. An investor received a replacement share for every ten shares held by them. The company's market valuation remained constant (at roughly $131 billion), even though the split lowered the number of shares outstanding from 29 billion to 2.9 billion.
You may receive fractional shares (7.5 in this case), and in some cases, you may receive cash in the amount of a rounding error, if fractional shares are not available, if the math doesn't work out evenly when effecting a reverse split. For instance, if you have five shares and there is a two-for-three reverse split and you have five shares. Cash in lieu is the name for this (CIL). CIL is viewed as a sale of shares for tax purposes.
Do stock splits affect short sellers?
Short sellers are not significantly impacted by stock splits. A split can cause some changes that may have an effect on the short position. However, they have no impact on the short position's value. The number of shares shorted and the price per share represent the biggest changes to the portfolio.
An investor who shorts a stock does so by borrowing the shares with the understanding that they would return them at a later date. For instance, if an investor sells 100 shares of XYZ Corp. short for $25, they will eventually have to give the loan 100 XYZ shares back. The number of shares in the market and the number of shares that must be returned will simply double if the stock experiences a two-for-one split before the shares are returned.
The value of the shares likewise splits when a firm divides its shares. Assume, for instance, that XYZ Corp. shares were trading at $20 at the time of the two-for-one split. Following the split, the number of shares doubled, and the shares now sell at $10 rather than $20. Following the split, an investor who previously owned 100 shares at $20 each for a total of $2,000 will now own 200 shares at $10 each for a total of $2,000.
In the case of a short investor, they owe the lender 100 shares before the split. They will owe 200 shares following the split (that are valued at a reduced price). If the short seller closes the position as soon as the shares are split, they must purchase 200 shares at a market price of $10 and give them back to the lender.
After deducting the cost of closing out the short position ($10 x 200), the short investor will have earned a profit of $500 (amount received from the short sale: $25 x 100). Consequently, $2,500 – $2,000 = $500. 100 shares at $25, or 200 shares at $12.50, were the entry price for the short position. With 200 shares borrowed, the short position earned $2.50 per share, or $5 per share on 100 shares if sold before the split.
Advantages of stock split to investors
The benefits and drawbacks of stock splits are hotly debated topics. A stock split, according to one side, is a good purchasing indicator, indicating that the company's stock price is rising and performing well. While this might be the case, a stock split simply has no impact on the stock's intrinsic value and offers little benefit to investors. Despite this, financial newsletters frequently pay attention to the generally favorable attitude around stock splits. There are entire periodicals devoted to following split-affected equities and trying to capitalize on their bullish characteristics. Critics contend that this tactic is hardly tried-and-true and, at best, has mixed results.
Considering commissions
In the past, purchasing before the split was a wise move because commissions were weighted based on the number of shares purchased. Only by saving you money on commissions was it beneficial. Since the majority of brokers now charge a fixed cost for commissions, this advantage is less useful today. This implies that their fees are the same whether you trade 10 shares or 1,000.
In conclusion
A company's stock shouldn't be purchased primarily due to a stock split. Although there are some psychological factors at play when corporations divide their shares, none of the business fundamentals are altered. Keep in mind that the split has no impact on the company's market capitalization. In the end, you have the same amount in the bank whether you have two $50 bills or one $100 bill.
FAQ
How can you take advantage of stock splits?
To be eligible for a split, you must be a shareholder as of a particular date that has been set by the corporation.
If a company's share price has decreased due to a stock split and you haven't invested in it yet, you should do some research on the stock to make sure it's a suitable fit for your portfolio before you buy.
Do all companies split their stock?
Companies that have seen a significant gain in the price of their shares are more likely to use a stock split. The market capitalization (and the worth of the company) remain constant despite a growth in the number of outstanding shares and a fall in the share price per share. As a result, stock splits increase the marketability and liquidity of shares while also making them more accessible to smaller investors.
How long does it take for a stock split to settle?
The effective date for a split announced by a firm is typically established 10 to 30 days after the announcement. The split is open to all stockholders who held shares on the trading day prior to the ex-date. The settlement of the shares could take a few more days.
Is it better to buy the stock before or after a split?
Usually, when a stock split is announced, the price of the stock increases. Investors might profit from this in an ideal world, but sadly, trading on the information of a stock split before it is publicly disclosed is seen as insider trading.
Which company has the highest number of stock splits?
Apple has the greatest number of stock splits to date.