A stock split is a corporate action event instructed by a company’s management team that changes the number of total shares in circulation.
If the company’s valuation remains the same whilst the stock split is processed, an increase in the quantity of shares available will result in the price of each share falling in value.
If, for example, the total number of shares is doubled in a two-for-one stock split, then the price of each share will fall by 50%. Each shareholder would hold twice as many shares as before, but each one of those shares would be half the value they previously were. Therefore, there is no change to the net value of the holding, but there is a change in the number of shares held.
Stock splits do not imply any change to the company’s day-to-day business operations. They are more of an accounting procedure firms use to manage the price of their shares on stock exchanges on which they are listed. The terms of the stock split, including the ratio of the split, and the date on which it will take place, are set by the company’s management and announced to the market in advance.
Why Do Firms Carry Out Stock Splits?
Although stock splits are a relatively straightforward process, there is still the question of why firms consider doing them at all. There are administration costs to consider, which will ultimately be passed on to shareholders in terms of a cost item on the balance sheet. There are also challenges relating to the price of a stock apparently ‘tanking’ overnight.
Cultural Reasons For Stock Splits
One reason that firms decide to put a stock split through is that investors get used to the way stocks are priced on a particular exchange. In the US, stock prices have historically ranged from $50 up to several hundred dollars. Dow and Cisco started 2022 trading near the $50 level, and Goldman Sachs and Home Depot, at the same time, were trading close to $400 per share. Apart from United Health ($460), the remainder of the firms in the index are priced between those lower and upper levels.
Anyone considering buying stock in a company might question those that are much higher or lower than the expected range. Companies are keen for their stock to attract attention from as wide a range of buyers as possible. Any kind of buying pressure supports the share price, so having a stock that has a price that is ‘off the scale’ or even ‘just a little bit odd’ puts unnecessary barriers in the way of attracting new investors.
Practical Reasons For Stock Splits
There is a more practical reason used to justify processing a stock split. This relates to the challenges facing investors with smaller sums of capital to invest. If a retail investor with $1,000 was looking to buy US tech stocks and follow the traditional advice of diversifying their capital across a range of positions, they would be challenged by Microsoft, Netflix and Nvidia having respective stock prices in the region of $300, $380, $230. Unless that individual’s broker offered ‘fractional trading’, then buying one Alphabet share for a price in the region of $2,600 would be out of the question.
Case Study – Tesla Stock Split
Tesla split its stock on a 5:1 basis in 2020. It followed a tweet from the enigmatic head of the firm Elon Musk, which stated that Tesla stock was “too expensive imo” (source: Twitter). The comment by Musk didn’t refer to the underlying valuation but to the nominal price of one share, which he stated was at a level that was prohibiting investors from being able to buy Tesla stock.
The reorganisation was announced on 11th August, and at the close of trading on 28th August, each investor received four new shares for each Tesla stock they were holding. The stock price readjusted from being as high as $2,213 in the week running up to the stock split August to open trading on 31st August at $418.
Tesla Motors Inc – Stock Price and Stock Split
One point to note is that charts at online brokers are by default set to factor in any stock splits. This is to make the analysis of price action easier than if there were significant cliff edges as price falls to the new level. The price for Tesla on 28th August 2020, the last trading session before the stock split, is now represented on that stock’s price chart as being in the region of $463, not $2,200.
Case Study – Apple Stock Splits
Tech giant Apple has been experiencing exponential stock growth for more years than Tesla and, to date, has put through five stock splits. The first was in 1987 and the most recent was in 2020. An early-bird investor who has held one Apple stock since it floated would now have a position size of 224 AAPL shares.
Apple Inc – Stock Price and Stock Split
Apple’s market capitalisation, its fundamental value, has remained stable through all of the splits, but each time, the number of stocks available to investors increased and the price of each share fell. On a chart where price is adjusted to factor in the stock splits taking place, the share price data doesn’t show the dramatic swings in nominal price.
Reasons Some Firms Don’t Carry Out Stock Splits
The most obvious reasons for not engaging in stock splits are the costs involved and the benefits of focussing on the day job. Stock splits generate media attention and involve senior management devoting time and resources to manage the process. There is also a requirement to engage third parties such as stock registrars to process the corporate action.
Investment guru Warren Buffet’s firm, Berkshire Hathaway, has resisted the urge to split its stock, which started trading in 2022 with a price tag of around $450,000 per share.
Berkshire Hathaway Inc A – Share Price Chart
Another reason to avoid stock splits is that a management team may feel the firm’s stock is overvalued. Splitting the stock to get it back down to $50 per share is a good idea unless there is a risk that investor sentiment might sour and take the future price sub $50. This would take the company into the ‘penny stock’ region. This could deter some investors and the firm could face the same problem of being out of the typical price – just at the other end of the spectrum.
What Is A Reverse Stock Split?
The unfortunate scenario outlined above, where a firm carries out a stock split on it’s overvalued shares and then finds them trading at an unattractively low level, partly explains the nature and purpose of a reverse stock split.
In a reverse stock split, the management of a company reduces the total amount of shares. This means that the price of each remaining share increases. As with standard stock splits, the underlying value of the firm isn’t altered by the process, but the share price is. As the natural direction for stocks is upwards, reverse stock splits are less common than stock splits.
Other Corporate Actions
Stock splits are different from two other common corporate actions that take place in the financial markets – dividends and stock buybacks. Dividends are where companies distribute a percentage of annual profits to shareholders in the form of a cash payment or additional shares in the firm. Buybacks are where the same spare cash is used to buy a company’s shares on the open market and then take them out of circulation. Dividends involve shareholders receiving a one off payment relating to their holding, and buybacks benefit shareholders thanks to the reduction in the supply of stocks, resulting in the price of the remaining shares increasing.