Understanding Stock Splits
Are they good for investors?
A stock split happens when a company decides to exchange more shares at a lower price for stockholders' existing shares. 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.
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.
For example, Apple carried out a 7-for-1 stock split in June 2014. Its per-share price was about $650 and after the split, it was about $93 per share. This was the fourth stock split by Apple.
2-for-1 Stock Splits
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.
Other Reasons for a Stock Split
Besides making the stock price more attractive to individual investors and so potentially expanding the shareholder base, there are a few more reasons a company might split its stock.
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 aids 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
Portfolio managers find it easier to sell shares to buy new ones when each share price is lower because 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.
Tends to Increase Share Prices
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.
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 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.
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-$3. In the week following the reverse stock split, it was about $18-$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.
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.
The Bottom Line
Stock splits happen and so it's important for investors to understand what it means for their investments. 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. Keep an eye on announcements from the companies you're investing in to be better aware of if and when a stock split may occur.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.
U.S. Securities and Exchange Commission. "Stock Splits." Accessed May 5, 2020.
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Nasdaq. "3 Compelling Reasons for Companies to Split Stocks." Accessed May 5, 2020.
Cambridge University Press. "Journal of Financial and Quantitative Analysis, Volume 31, Issue 3: What Do Stock Splits Really Signal?" Accessed May 5, 2020.
SSRN. "Do Stock Splits Really Signal?" Accessed May 5, 2020.
Investor.gov. "Reverse Stock Splits." Accessed May 5, 2020.
USCF Investments. "USCF Announces One-for-Eight Reverse Share Split for the United States Oil Fund." Accessed May 5, 2020.
Yahoo! Finance. "United States Oil Fund, LP (USO)." Accessed May 5, 2020.