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What is a Stock Split?

| MoneyRates.com Senior Financial Analyst, CFA
min read

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At the end of August, 2020, Apple and Tesla issued stock splits. Having two such high-profile companies split their stocks at the same time got a lot of investor attention.

But was it really such a big deal?

To answer that question, it helps to know about stock splits and how they work.

Small investors typically move beyond the basic questions like "What is a stock split?" very quickly. The reason is that, in order to evaluate whether a stock split makes a company a good investment or not, they need to learn about these things too:

  • What happens to stock prices when a stock splits?
  • Why do stocks split?
  • What do reverse splits mean?
  • How does a stock split affect the value of a company?
  • When do stocks split?
  • How do stock splits affect dividends?
  • How do you check the impact of a stock split on your holdings?

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What is a Stock Split?

A stock split is a corporate action approved by a public company's board of directors. Corporate actions are major organizational changes that affect shareholders.

When a company originally issue shares, it is essentially selling a portion of that company to the public. The portion being sold is divided into a large number of shares to make them affordable to ordinary investors. The number of shares you buy determines how much of the company you own.

A stock split is when a company issues additional shares to current stockholders in proportion to the number of existing shares they own. For example, a 2-for-1 stock split means that you get two new shares in the company for every existing share you own.

Those new shares now become the units of company ownership that are publicly traded on a stock market.

As the name suggests, a stock split is as if each existing share split into a number of new shares. The split ratios don't have to be a 2-for-1 split. Apple's 2020 stock split, for example, was at a 4-for-1 ratio; Tesla's was at a 5-for-1 ratio.

What is a Reverse Stock Split?

Stock splits can also work the other way. Instead of issuing multiple shares for every existing share, a company may decide to merge multiple existing shares into one new share.

This is known as a reverse split. As an example, a 1-for-2 reverse split would mean that you get one share for every two of the current stock shares you own.

How Does a Stock Split Affect the Price Per Share of a Company?

On the surface, a stock split might sound like a good deal for shareholders, and a reverse split might seem like a bad deal. That's because, with a split, you end up with additional shares while you end up with fewer shares in a reverse split.

However, that's not the best way to look at it.

Because stock splits affect the publicly traded shares of all shareholders equally, after the split you would own the same portion of the publicly traded shares as before.

Knowing this, investors adjust the price they are willing to pay for a company accordingly. A simple example can help illustrate how this works:

Let's say you own 100 shares of a company trading at $40 per share. The current value of this investment, therefore, would be $4,000.

Now suppose that company issues a 2-for-1 stock split. You now own 200 shares. However, since the number of shares has doubled for everybody, each share should be worth half as much.

Therefore, the new shares are likely to have a value of $20 each. At that price, your 200 shares would have a total value of $4,000, the same as the value of your holdings before the split.

As you might expect, with reverse stock splits, prices adjust in the opposite direction. So, in a 1-for-2 split, the number of shares you own would be cut in half, but the price would double. As with a regular stock split, this should leave the total value of your holdings in the company unchanged.

Does a Stock Split Make a Company More or Less Valuable?

As described above, in the case of both stock splits and reverse splits, the price per share should adjust in the opposite direction, in proportion to the type of split. This should leave the value of your stock holdings unchanged.

However, stock prices are determined by trading activity on public exchanges, and the public doesn't always act rationally.

Stock splits often generate a lot of investor attention, which can pump up a stock's price. Splits can also help make shares more accessible to small investors, which could have an incremental effect on demand for the stock.

However, savvy investors know that, when you look past that, a stock split does not change the fundamental value of a company.

After all, if 100% of a company's ownership is divided into 1 million shares, a 2-for-1 split resulting in a total of 2 million shares would not magically make the company twice as valuable post split. There would be twice as many shares, but each of those shares would be worth half as much of the company's ownership as a pre-split share.

Think of this like cutting a pie. Whether you cut the pie in four large slices or eight smaller slices, it is still the same total amount of pie. So, if a company splits from 1 million shares outstanding to 2 million, the value of the company is still the same.

Why Do Stocks Split?

If a stock split doesn't fundamentally affect the value of a company, why do companies do them?

To a large extent, publicly traded companies are looking to maintain share prices that will make their stocks accessible and appealing to investors.

For example, if a stock is trading for $40 per share, it would take $4,000 to buy 100 shares, which is a fairly standard trading increment.

If that company's share price were to rise to $200 per share, it would now take $20,000 to buy 100 shares. Fewer investors could afford that large of an investment, so this could adversely affect investor demand. A 5-for-1 stock split could bring the price back to $40.

The psychology of stock splits

There's also a psychological effect here. To some investors, a $200 stock seems more expensive than a $40 stock. Therefore, if the company did a 5-for-1 stock split, the shares might seem like a bargain at $40 per share, because investors were used to seeing the company trade at $200 a share.

Of course, this isn't really a bargain since those cheaper shares would now be worth one-fifth as much of the company as a share before the split.

Reverse splits may be done to bolster a price which has fallen badly. In particular, when stocks fall below $5 per share, it can hurt their appeal to investors.

After all, the closer a price gets to zero, the more nervous investors are likely to get thinking the company may become worthless. Also, a very low price might result in a company's stock being de-listed. This means being kicked off a stock exchange.

So a 1-for-2 reverse split can bump the price of a $5 stock up to $10. This may be more appealing to some investors, and may have the practical value of helping a stock continue to trade on an exchange longer.

In the end, though, a price bump from a reverse split would not address the fundamental problems with the company that caused the price to drop to $5 in the first place.

How Do Stock Splits Affect Dividends?

If you own a stock that pays a dividend, can you expect more dividends if the stock splits?

Not really.

While you would now have more shares that each pay a dividend, the value of the dividend per share would most likely drop in reverse proportion to the split.

So, if you owned 100 shares of a stock paying a 50-cents-per-share dividend, after a 2-for-1 split you'd likely see that dividend cut to 25 cents per share. Either way you'd be earning a total cash dividend of $50.

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See How Stock Splits Impact Your Holdings

If you own stocks in mutual funds, either directly or through a portfolio managed by a robo-advisor or a financial advisor, you won't directly see the impact of a stock split in your holdings.

If you own individual stocks directly, the impact of a stock split should be automatically reflected in your account. However, it makes sense to see that your number of shares has been increased in proportion to the split.

One benefit of an online brokerage account is that you should be able to see the impact almost immediately. That would allow you to promptly contact the broker if there appears to be a problem. It is important to address any problems like this as soon as possible because they could complicate future dividend payments and trading activity.

For all the fuss made about stock splits, they don't fundamentally change the value of a company. They can have a slight impact on demand for a stock by keeping the price at an attractive level. To each investor, though, the change in the number of shares should be offset by a change in prices.

Still, it is important to understand stock splits so you don't get sucked in by the hype, and to make sure the shares in your account are adjusted properly.

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