What Are Stock Splits?
Investors have probably heard about stock splits but may not understand how they work or why companies would “split their stock.”
A stock is split when a company decides to increase its number of shares. A basic example might be a company with 50 mln shares outstanding and a $200 stock price. By announcing a 4-for-1 split, that would result in 200 million shares outstanding and a $50 stock price. The market capitalization – or value of the company -- does not change. So, if you own 100 shares in that company, you will now own 400 shares, but the value of each share will be reduced.
There are also reverse stocks splits, but that’s usually only for very low-priced stocks. For example, a $2 stock might do a 1-for-10 reverse split, which reduces the number of shares outstanding but increases the price to $20. The idea here is that a $20 stock is seen as less speculative than a $2 stock. Also, there are a lot of mutual funds prohibited from owning stocks under $5, so a reverse split would enable them to buy the stock.
Why do a stock split?
Companies may not admit it, but the main reason is to boost the stock price. Typically, the announcement itself will give the stock a boost, plus the more lasting impact is hope that a cheaper stock price over time will entice more investors to buy the stock. A basic stock split also improves the liquidity of a stock because it increases the number of shares in circulation. However, it does not change your percent ownership in the company.
Smaller retail investors generally prefer to buy lower-priced stocks. For example, an investor with a $10,000 portfolio may shy away from buying Apple (AAPL) at $720 per share because even just a few shares would eat up a good chunk of his or her portfolio. However, Apple did a 4-for-1 stock split in August 2020 and now it’s trading around $180, which is more palatable for the average investor.
There is also a psychological aspect to it. If a $50 stock goes up $1.00, that’s a 2% move, whereas a $1.00 move in a $100 stock has less impact. We agree it should not make a difference, but some investors think this way, hence the allure of low-priced stocks for some people.
Conclusion
A stock split should have little to no impact on your investment decision as the valuation metrics do not change. However, the truth is that humans trade stocks and psychological factors do play a role in stock selection. Many people prefer not buying $1,000+ stocks. Also, we recommend that investors not make investment decisions based on the hope a company splits its stock. An investment decision should be based on the fundamentals of the company and on valuation.
You can track announced stock splits page by using Briefing.com’s Stock Splits page, which appears under the Calendar tab on the main menu.
