A stock split is when a company lowers the price of its stock by splitting each existing share into more than one share. Because the new price of the shares correlates to the new number of shares, the value of the shareholders' stock doesn't change and neither does the company's market capitalization.
Companies carry out a stock split for the purpose of lowering the individual share price. A lower share price can make the stock more attractive to a broad range of investors, not all of whom could afford a stock priced at, say, $1,000.
What Are Stock Splits?
Stock splits happen when a company decides to split one share of its stock into more shares. For example, a company might take one share of stock and split it into two shares. The total combined value of the two new shares still equals the price of the previous one share. For instance, if Company ABC completed a 2-for-1 stock split, and the original share price was $20 for one share, the new shares would each be priced at $10.
In a stock split, investors who own shares still have the same amount of money invested, but now they own more shares.
How Does a Stock Split Work?
Publicly traded companies, including multi-billion dollar blue-chip stocks, do this all the time. The firms grow in value thanks to acquisitions, new product launches, or share repurchases. At some point, the quoted market value of the stock becomes too expensive for investors to afford, which begins to influence the market liquidity as there are fewer and fewer people capable of buying a share.
Let's say publicly traded Company XYZ announces a 2-for-1 stock split. Prior to the split, you own 100 shares priced at $80 each, for a total value of $8,000.
After the split, your total investment value remains the same at $8,000, because the price of the stock is marked down by the divisor of the split. So an $80 stock becomes a $40 stock after the 2-for-1 split. Post-split, you now own 200 shares priced at $40 each, so the total investment is still worth the same $8,000.
Types of Stock Splits
The most common types of stock splits are traditional stock splits, such as 2-for-1, 3-for-1, and 3-for-2. In a 2-for-1 stock split, a shareholder receives two shares after the split for every share they owned prior to the split. In a 3-for-1 split, they receive three shares for every share, and in a 3-for-2, they receive three shares for every two.
If a company's stock price has gotten very large, many more shares could be exchanged after the split for every one prior to the split.
One example is tech giant Apple. On Monday, Aug. 31, 2020, Apple split its stock 4-for-1, which means investors who owned one share of the stock now own four shares. Before the stock split, one share of Apple cost $499.23 (at closing on Friday, Aug. 28, 2020). After the split, shares were about $127 each. While this made the stock more accessible to investors, this was not the first time Apple split its stock. In fact, this was the fifth stock split since Apple's IPO in 1980. In its last stock split in June 2014, Apple split its stock 7-for-1. Its per-share price was about $650 and after the split, it was about $93 per share.
Another example is Tesla, the electric car company. Tesla split its stock 5-for-1 on Monday, Aug. 31, 2020. Prior to the split, a share of Tesla cost about $2,213 per share (at closing on Friday, Aug. 28, 2020). After the split, shares were about $442 each.
Some may wonder why a company wouldn't split a stock, and a good example is Berkshire Hathaway. Over the years, Warren Buffett never split the stock. As of market close on Aug. 28, 2020, one share of Berkshire Hathaway Class A stock traded at $327,431—far outside of the realm of a vast majority of investors in the United States and, indeed, the world.
Buffett eventually created a special Class B shares. This is an example of a dual-class structure. The B shares originally began trading at a 30th of the Class A share value (you could convert Class A shares into Class B shares but not the other way around). Eventually, when Berkshire Hathaway acquired one of the largest railroads in the nation, the Burlington Northern Santa Fe, it split the Class B shares 50-for-1 so that each Class B share is now an even smaller fraction of the Class A shares. As of market close on Aug. 28, 2020, Class B shares traded at $218.55, which is much more accessible for investors.
Pros and Cons of Stock Splits
Makes portfolio rebalancing simpler
Makes selling put options cheaper
Often increases share price
Could increase volatility
Not all stock splits increase share price
If a stock’s price rises into the hundreds of dollars per share, it tends to reduce the stock's trading volume. Increasing the number of outstanding shares at a lower per-share price adds liquidity. This increased liquidity tends to narrow the spread between the bid and ask prices, enabling investors to get better prices when they trade.
Makes Portfolio Rebalancing Simpler
When each share price is lower, portfolio managers find it easier to sell shares in order to buy new ones. Each trade involves a smaller percentage of the portfolio.
Makes Selling Put Options Cheaper
Selling a put option can be very expensive for stocks trading at a high price. You may know that a put option gives the buyer the right to sell 100 shares of stock (referred to as a lot) at an agreed-upon price. The seller of the put must be prepared to purchase that stock lot. If a stock is trading at $1,000 a share, the put seller has to have $100,000 in cash on hand to fulfill their obligation. If a stock is trading at $20 a share, they have to have a more reasonable $2,000.
Often Increases Share Price
Perhaps the most compelling reason for a company to split its stock is that it tends to boost share prices. A Nasdaq study that analyzed stock splits by large-cap companies from 2012 to 2018 found that simply announcing a stock split increased the share price by an average of 2.5%. In addition, a stock that had split outperformed the market by an average of 4.8% over one year.
In addition, research by Dr. David Ikenberry, a professor of finance at the University of Colorado's Leeds School of Business, indicated price performance of stocks that had split outperformed the market by an average of 8% over one year and by an average of 12% over three years. Ikenberry's papers were published in 1996 and 2003, and each one analyzed the performance of more than 1,000 stocks.
An analysis by Tak Yan Leung of the City University of Hong Kong, Oliver M. Rui of China Europe International Business School, and Steven Shuye Wang of Renmin University of China looked at companies listed in Hong Kong and also found price appreciation post-split.
Could Increase Volatility
Stock splits could increase volatility in the market because of the new share price. More investors may decide to purchase the stock now that it is more affordable, and that could increase the volatility of the stock.
Many inexperienced investors mistakenly believe stock splits are a good thing is because they tend to mistake correlation and causation. When a company is doing really well, a stock split is almost always inevitable as book value and dividends grow. If a person sees or hears about this pattern frequently enough, the two may become associated.
Not All Stock Splits Increase Share Price
Some stock splits occur when a company is in danger of having its stock delisted. This is known as reverse stock splits. While investors may see the per-share price go up after the reverse split, the stock may not grow in worth after the split, or it may take a while for it to recover. Novice investors who don't know the difference could end up losing money in the market.
What Are Reverse Stock Splits?
Splits in which you get more shares than you previously had but at a lower per-share price are sometimes called forward splits. Their opposite—when you get fewer shares than you previously had at a higher per-share price—are called reverse splits.
A company typically executes a reverse stock split when its per-share price is in danger of going so low that the stock will be delisted, meaning it would no longer be able to trade on an exchange.
It might be wise to avoid a stock that has declared or recently undergone a reverse split unless you have reason to believe the company has a viable plan for turning itself around.
A good example of a reverse stock split is the United States Oil Fund ETF (USO). In April 2020, it had a reverse stock split of 1-for-8. Its per-share price before the split was about $2 to $3. In the week following the reverse stock split, it was about $18 to $20 per share. So investors who had, say, $40 invested in 16 shares of USO at about $2.50 each, ended up with just two shares valued at about $20 each after the reverse split.
- A stock split is when a company lowers the price of its stock by splitting each existing share into more than one share.
- A popular stock split is 2-for-1, where investors receive two shares for every one share they previously owned before the split.
- Large companies often split stocks to make them more accessible to investors.
- Apple and Tesla both split their stocks on Aug. 31, 2020, while Berkshire Hathaway has never split its Class A shares.
- While forward splits and reverse splits both have no impact on the total amount an investor has invested in the stock or fund, the former is considered a positive and growth move by the company, while the latter is to help prevent the stock from being delisted on the exchange.
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