5 Keys to Understanding Stock Splits

Stock splits matter because they result in increased market liquidity. When Apple conducted a 7-for-1 split in 2014, the stock price went down, trading volume went up, and the stock became more affordable for retail investors.

This move often acts as an expression of the company’s confidence in its growth, which in turn garners investors’ favor and often leads to a hike in stock value, as observed in the case of many other companies.

5 Keys to Understanding Stock Splits

What Are Stock Splits?

In simple words, a stock split is a process in which a company divides the number of its existing shares to increase the liquidity of the shares. While the number of shares increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts. Accordingly, a stock split does not add any real value; the most common splits are 2-for-1 or 3-for-1. In these cases, a shareholder no possesses two to three shares for every share they owned before.

To explain, if one holds 100 shares in a company and there is a 2-for-1 stock split effectuated, the shareholder then holds 200 shares. However, the market price per share is cut in half, implying that the worth of the stake held by the shareholder remains the same, being 100% of its pre-split value.

This decision is generally made by companies that see their share price go to levels that are either too high or above the price levels of peer companies in the sector. The idea is that by making shares affordable, it widens the pool of investors who can afford to buy them . In this regard, take the example of Apple Inc., which undertook a 4-for-1 stock split on August 31, 2020. At the time, the stock was trading at almost $500 a share, and the split adjusted the market-share-cost to around $125. As a result, Apple’s stock shares became affordable for an even large number of investors, which usually has the effect of improving market liquidity and ownership.

Finally, another purpose can also lie behind this decision-making process: making a stock seem more active. Considering that more stock shares can be bought and sold without a significant investment, a lower price per share logically seems to imply a higher frequency of transactions, thus nominal liquidity. However, while the mechanics of a stock split are straightforward, the decision’s impact can greatly vary on the execution and timing and market perception. Some corporations have even seen the value of their shares increase post-split, as was the case with companies such as Google or Amazon.

How Stock Splits Affect Shares Outstanding

When a company declares a stock split, the total number of shares outstanding increases in multiples of the split ratio. Thus, if in a 2-for-1 stock split, each share held becomes two equity securities. However, the most crucial point to remember is that the additional share issue does not infer a surge in the total value of equity owned. Rather, shares are doubled to reflect the sum value held by the shareholder before the split. For example, if a company valued at $100 per share in 1 million shares executes a 2-for-1 split, the equity will be valued at $50, while the total shares increase to 2 million. Therefore, the company’s market cap will remain $100 million, but because it is now distributed across more outstanding shares, every shareholder now owns double the number of shares. The most important effect of this action, therefore, is the apparent effect on shares’ interpretation and trading.

The split offers a perception of reduced share value, but overall market value remains unaffected. One potential benefit is that having more equity securities on issue ensures higher liquidity, reducing pressure on the price. The shares’ improved liquidity stream is likely to attract more investor interests, further reducing the scope for price volatility. Moreover, it is argued that stock splits may hold special appeal in industries where share price is high. Some technology giants, like NVIDIA, Amazon, Tesla, and Netflix, are frequent stock splitters, as high stock prices may reduce the attractiveness of the equity to shareholders.

For example, Tesla recently announced a 5-for-1 split, which took place in August of 2020. Here, a strong stock split rationale was likely due to the high price of the company’s shares. Alfarone cited Claude Erb, a lecturer at the National University of Singapore, who argued that the stock split was an effort to democratize stock ownership .

Lowering stock price could have enabled more investors to purchase the stock, in line with Musk’s strategy to become less and less expensive over time. fullPathTo root public url/The reasons for stock splits cited in the literature could offer one explanation. Erb also pointed out that stock splits tend to comfort the market, signaling that the company’s board believes the stock’s high price is sustainable. Thus, it also plays a certain psychological role and can add to excitement in the market and a potential surge in market value.

Calculating New Share Distribution

Although calculating new share distribution following a stock split is nothing but straight-out math, understanding the impact of this phenomenon still requires a solid understanding of its basics. Overall, the formula to compute the subsequent number of shares following a stock split is: number of original shares owned * split ratio. For instance, one could imagine that an investor owns 300 shares of a certain company. This company decides to go through with a 3-to-1 stock split. In this case, this investor’s subsequent number of shares owned will be equal to:

300 shares * 3 = 900 shares .

Meanwhile, for every shareholder, this formula does not change: everyone multiples the previous number of owned shares by one distinct given ratio. In the meantime, with the price per share, the logic will be reversed: it will be equal to the price per share before the split divided by the split ratio. In this case, if the starting price per share were $150, then the new price of a single share would be the succeeding:

$150 / 3 = $50 per share .

Such math is logical, for it ensures that the overall market value of one’s shares is the same right before and after the split . Meanwhile, it’s essential to keep in mind that it is so only in a perfect world, as in real life, the initial and post-split overall values will, of course, be somewhat varying. For example, before the split, an investor with 300 shares of a $150 company would have their bonds cost:

300 * $150 = $45,000 .

Meanwhile, following the 3-to-1 split, it will cost a different number of shares, amounting to:

900 * $50 = $45,000 .

Essentially, it indicates that clients’ number of owned shares and their price are changing, and the overall remains the same. That’s the average property that all need to get into their system because it is the explanation from which another fundamental idea stems: a stock split per se does not make the investment one’s ownership more valuable. Regarding a fraction of shares, companies will either offer to pay the owner in cash or round up to the nearest whole number in any logical circumstances causing the emergence of half shares.

Investor Reactions to Splits

Investor reaction to stock splits can be highly dynamic. Indeed, while a stock split does not change a company’s market cap, it has a tendency to excite investors and lead to growth in stock prices. One of the reasons for it is that investors perceive such splits as a signal that higher share prices are sustainable, and the subsequent growth in share prices might follow this view. Indeed, when a company like Apple or Amazon announces that it plans to split stock, retail investors typically see it as the company’s shares being “on sale”, even though the variable today is split and tomorrow. The data has shown that stock splits result in a significant market reaction and lead to the short-term appreciation of stock prices.

Shortly, stock prices will usually gain in value following stock splits, currently. Parts of the reasons for it are that splits increase a stock’s liquidity and its accessibility , which causes investors to perceive them as not overpriced. Split announcement is followed by an increase in trading volume, and the price of shares will typically grow . One example of this trend may be observed with Apple’s 7-for-1 stock split that took place in June 2014. In this case, shares have been trading at about $645 a share before the split and at an equivalent of $92 each after the split was completed in June . Despite the oversell, Apple shares saw a significant market rally, with the stock recording as high as a 36% gain in a span of a year .

At the same time, the reaction differs to some extent depending on market conditions. Indeed, some investors are highly likely to discount stock splits as merely cosmetic changes and unwarranted exuberance when companies do not have sustainable underlying financial conditions. In particular, such reactions might be more common during bear markets or when companies lack strong fundamentals. In this regard, strategic investors tend to pay attention to the rationale behind stock splits, searching for clues regarding whether the split is part of a larger growth story or as simple as boost a stock’s price without fundamentally altering the underlying growth story.

Long-Term Impact on Stock Value

It is necessary to distinguish between immediate and long-term impacts when determining the permanent effects of stock splits on the value of a company’s stock. In the shorter term, as has been mentioned, because of an increase in accessibility and liquidity, stock splits tend to increase the prices of shares.

Such higher prices do not reflect any intentional increase in the “real” value of shares; the only difference between the situation before and after the split is that there are now more shares, each worth less.

An increase in value might repeatedly occur in the days following a stock split; some companies that split their stock include Amazon and Netflix , which both exhibited clear long-term price increases on the graph. Although this factor may highlight the importance of value in the long-term growth of a company, it is not due to the split itself.

The reason for Amazon and Netflix price growth is that they are companies with strong growth and a sustainable revenue model, meaning that they are good investments. As a result, similar to what happened after the 7-for-1 split, Apple’s value grew not only due to the increase in prices but also continued to publish good results to explain the rise in its value in the months and years following the split. I think that successful companies will perform a stock split only when they are already doing well as a way to keep value increasing.

There is an additional advantage to the possibility of greater liquidity with a larger number of shares in circulation at the same price – investors and traders do not need to spend as much care about the potential impact of their purchase or sale on the stock price. Finally, people may be more likely to invest in a company’s shares following a split because they are now within everyone’s reach and not at $1,000 per share.

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