With stock splits in the news this 2020 (thanks to Apple & Tesla), we want to touch on what this term means, the process of splitting stocks and how it affects investors.
TL;DR
- Stock splits are a type of corporate action. The companys executives increase the number of shares, giving existing shareholders more stocks proportionate to the split ratio.
- The price per stock also decreases proportionate to the split ratio.
- Companies choose to split stocks to invite smaller investors and increase stock liquidity.
- Stock splitting does not change the company value.
- Splitting stocks can affect market demand, which affects price per stock after the initial decrease of price per share.
- Because of an increase in popularity of index funds and ETFs, stock splitting is less common than it used to be. But it hasnt gone away, and Apples August 2020 move is proof.
Stock splits, defined
During the initial public offering (IPO), banks determine how many shares a newly public company will have and what the cost of each of those stocks will be. But as a company grows in the public eye, they may decide to increase their number of available stocks.
A stock split is a type of corporate action that occurs when a companys executive board chooses to increase the number of shares by giving more stocks to their existing shareholders.
For example, a company may go for a 2-for-1 stock split (a number known as the split ratio), which effectively multiplies the amount of available shares by two. Another common option is a 3-for-1 stock split, which multiplies the amount of available shares by three.
Keep in mind that a company is not merely adding shares to the market, but multiplying the number of shares that all existing shareholders have. Eventually, existing shareholders spread this around to new investors through the act of stock trading.
Reasons why companies split their stocks
The main reason why companies take the route of stock splits is to control their share price. Sometimes, companies see their share price skyrocket beyond the industry market. Stock splits are an attempt to quell this. It opens the door for smaller investors and increases the stocks liquidity (AKA easy ability to be converted to cash).
Splitting stocks does affect existing and future shareholders at least temporarily but it doesnt change the companys market capitalization (AKA company value). If a companys stocks were slices of a pie, the slices just got smaller, but the size of the pie itself stays the same. And since shareholders now have more slices, the value hasnt changed.
How stock splits affect investors
Youre probably wondering what happens to my shares when a stock splits? When a stock split occurs, the effect on investors is multifaceted.
When a company decides to split their stocks, this move affects the price of each share. The price of each share immediately goes down, which makes sense considering theres now more shares representing the same amount of company assets. In a 2-for-1 stock split, share prices are cut in half. In a 3-for-1 stock split, those prices are cut by a third. Ultimately, shareholders maintain the same equity, split up in a different way.
Heres a formula to help you figure out your new price per share, regardless of split ratio:
Current stock price / split ratio = New stock price
This price decrease isnt permanent, though. After a decrease, youll often see a boost in share price. This is a natural effect of market demand. When small investors hop on the bandwagon and invest in the lower priced stock, they lift demand and increase prices.
Thats not the only reason prices of split stocks increase, though. If you think about it, the whole reason a stock splits in the first place is to bring down prices that were driven up by the companys success. The market assumes a companys success is only going to continue in the future. Its a perception of demand that ends up increasing demand.
With all this in mind, we know that existing shareholders will see their number of stocks increase while the value of each stock drops at a proportionate rate but this isnt for long. Prospective investors will have a chance to jump in on a share (or more), and access wont be limited to those who can afford a high premium. With the effects of market demand, the companys shares will rebalance itself with (hopefully) a new population of small investors.
Note: Stock splits dont affect short sellers in any tangible way.
The stock split process
Who sets the terms for stock splits? Mostly, its the Depository Trust & Clearing Corporation (DTCC) and the Options Clearing Corporation (OCC). The DTCC provides clearing and settlement services to the US financial market. The OCC is a US clearing house serving 16 major stock exchanges. Along with the company, these two organizations help put the corporate action into, well, action.
The company that is splitting their stocks will specify a date that investors need to be a shareholder by in order to take advantage of their split stocks. For example, Apples 2020 deadline for shareholders is August 24. This stock split has a 4-to-1 split ratio. By August 31, shareholders will receive four times the amount of stocks that they previously held, with each being valued at a fourth of the previous price.
Are stock splits common?
These days, stock splits are a lot less common than they used to be. Back in 1997, 102 companies within the S&P 500 index split their shares. In 2016, this number was down to just seven companies. In 2018, a mere five.
Experts largely attribute this decrease in stock splits to an increase in index fund and exchange-traded fund (ETF) investment popularity. But the downturn doesnt mean theyre not happening, as evidenced by Apples 2020 move as well as all the hubbub around it. And when they do happen, investors want to know whats going on.
What about a reverse stock split?
We know that a stock split is when a company increases its number of shares. On the opposite end of the spectrum, a reverse stock split is when a company decreases its number of shares.
And unlike companies looking to decrease their price per stock through stock splitting, publicly traded companies who perform a reverse stock split are looking to increase their price per stock.
Companies with consistently low share prices tend to lose favorability in the market. This perception from investors only stifles the share value even further. If their share price gets too low, they may even be delisted by their stock exchange (this depends on which stock exchange were talking about; each one has its own protocol on when to delist a stock when it falls too low, if at all).
Bottom line
Stock splits dont change a companys value, but they do increase the number of stocks each existing shareholder gets. At the same time, they reduce the value of each of those stocks. This courts new investors and helps increase the companys stock liquidity. The stock split process can also affect market demand, which naturally shifts the value of the stocks. While theyre not as common as they used to be, stock splits are still newsworthy, and something investors want to pay attention to.