Understanding Stock Splits
Are they good for investors?
Stock splits may seem like a gift to some investors, but there is little evidence that you actually benefit in any meaningful way when a company splits its stock, even though it you now have more shares.
Here’s an example of what happens when a stock split takes place. Amalgamated Kumquats, Inc., which is currently priced at $80 per share, announces a 2-for-1 stock split. If you own 100 shares before the split, worth $8,000, you will own 200 shares, but they're still worth $8,000, after the split.
Your total investment value remains the same, because the market automatically marks down the price of the stock by the divisor of the split. The $80 per share price becomes $40 per share after the stock splits.
There are other splits such as 3-for-1 and 3-for-2. However 2-for-1 seems the most common stock split.
In terms of what your holdings are worth, nothing changes. In terms of what the company is worth, nothing changes. So, why do it?
Reasons to Split
- Perception: Some companies worry when their per-share price gets too high that it will scare off some investors, especially small investors. Splitting the stock brings the per share price down to a reasonable level that's within the purchasing range of many investors.
- Liquidity: If a stock’s price rises into the hundreds of dollars per share, it may reduce the stock's trading volume. Increasing the number of outstanding shares at a lower per share price aids liquidity.
Is It Good for Investors?
Some investors say a stock split is a sign that a stock is doing well and they consider it a buy signal. But you should caution reading too much into a stock split by itself.
Always look at the whole picture before making an investment decision. If you want to use stock splits as a marker for stocks to consider for further evaluation, that is a reasonable idea, but don’t stop there with your research.
When to Use Caution
Pay attention and watch out for one type of split as a possible danger signal, and that’s the reverse split.
In a reverse split, the company reduces the number of outstanding shares and the per share price rises accordingly.
For example, a company might execute a 1-for-2 reverse stock split, which means for every two shares you own, you would now own one and the per share price doubles.
A reverse stock split is often used to prop up a stock’s price since the price rises on the split. Often a company will do a reverse split to keep the stock price from falling below the minimum required by the stock exchange where it is listed.
It is often a sign that something is wrong when a company can't keep its stock price above the exchange’s minimum listing price, and caution is advised when considering this type of investment.
Should You Buy Before or After a Split?
When you paid stockbrokers based on the number of shares you purchased, it made sense to buy a stock before it split. However, most brokers now charge a flat fee, so timing a purchase before or after a split doesn’t make much sense from that perspective.
Ultimately, it's best to buy a stock based on whether it meets the fundamental standards you require and not on whether it will or will not split.