There are various practices that take place in the stock market. The management and few by regulators execute few of them. It is important that smaller, retail investors understand them and try to use them to their advantage. One of the most common yet misunderstood practices is the stock split. In this article, we will decode the dynamics of a stock split and how it affects an investor and their investments. Let us jump right in.

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How a stock split works?

As the name suggests, a stock split is a process where the number of outstanding shares of a listed company is split or changed. The overall enterprise value does not change but since the total number of shares changes, the value of each share changes as well. Let us simplify this.

For example, a company has 1 billion outstanding shares and each share is worth USD 10. A split is carried out in various ratios. A 2 to 1 split will mean that the company now has 2 billion outstanding shares worth USD 5 each. The value of the company is unchanged at USD 10 billion. Similarly, a 5 to 1 ratio would value each share at USD 2 with a total of 5 billion outstanding shares. It is important to remember an investor is not getting any additional shares. His share is divided that is all.

Why do companies split stock?

A stock split is done primarily to change the liquidity of a stock and make it more attractive to investors. Many smaller investors are not able to buy expensive shares and hence let go of the opportunity to invest at all. For example, Amazon’s stock at USD 3000 may not be affordable for smaller investors. If Amazon goes ahead with a 10 to 1 split, the price of USD 300 is bound to be more attractive. In the process, since the number of shares is increased by 10 times as well, there is the increased scope of a greater number of investors latching on to the stock. The supply of shares increases and those shares are cheaper too. It is a win-win for new investors. However, what about investors already holding the stock?

How does a stock split affect you?

If you are invested in Amazon and fear a split will decrease the value of your investment, do not worry, a stock split objectively changes nothing. If you held 10 stocks of Amazon at USD 3000, you would hold 100 stocks at USD 300. Your investment value does not change one bit. For every 1 share held by someone, he is given 9 more shares for a 10 to 1 split. 4 for every 1 held if it’s a 5 to 1 split and so on. In addition, reiterate a split does not mean you are being given extra shares.

Let us take the example of pizza. Suppose you have 2 slices of an 8 slice of pizza. Now, you split your 2 slices into 4 slices and further into 8 slices. This does not mean that your original portion has increased. All those slices put together will still add up to your original 2. Do not confuse the extra quantity with extra weightage. Hence, just because a stock has announced split does not mean your investment value will go up.

Is a stock split good or bad?

A stock split does not change anything for the company apart from changing the liquidity of its shares. The fundamentals and valuation of the business are the same. It just gives the company an opportunity to increase its reach among smaller investors. If you think the company has a great scope and with an increased number of shares, more people will want to buy it, then a split can be considered positive.

On the other hand, there can also be a perception of loss of exclusivity. Expensive stocks are usually held over years by investors and stay a part of their portfolios. Opening it up to more investors may increase the volatility in its share price and hence that could be considered a negative. When smaller investors get an opportunity to buy shares, there is a lot of trading that happens in those stocks as well. In addition, it becomes susceptible to larger number of people’s perceptions.

It all boils down to the lens you are viewing the company and its stock from. But apart from the number of shares, nothing objectively changes, for the company or the investors.

Reverse stock split

There is not just one kind of stock split. There is something known as reverse stock split as well. While a forward or general stock split is used to increase the number of outstanding shares of the company, a reverse stock split is used to reduce the number of shares. But why would a company want to reduce its shares when we discussed how increasing them enables them to reach out to more investors?

This is not a common practice but is usually done for primarily two reasons.

The first is a technical one. Few exchanges have certain rules where the stocks may be delisted if they drop below a certain price. Hence, in such exceptional cases, companies may opt for a reverse stock split. This could happen when the stock has fallen quite a bit or when the exchange updates or changes its listing rules.

The second reason is to counter the con we discussed of having excessive shares. If the management feels there is a very high level of speculation happening in their stock, which is creating a roadblock for long-term investors, they could opt for a reverse stock split to make the stock difficult to get into. This reduces the volatility and could be a signal to long-term investors that the management wants them to stay on board. This does eliminate smaller investors and traders but some stocks prefer to have a better quality of investors than quantity.

So how does a reverse split work? The concept is similar. If you have 10 stocks at USD 100, after a reverse stock split of 1 to 5, you will now have 2 stocks priced at USD 500. Moreover, here too the valuation of the enterprise remains unchanged.

Example

Various companies have carried out stock splits. One of the most famous and successful recent examples of a stock split is that of Tesla. As we know, Tesla has been one of the most famous stocks in recent times thanks to their incredible tech as well as their CEO Elon Musk. Tesla’s stock had been on a tremendous bull run in 2020 and had run up by almost 400%. Hence, the management decided to opt for a split as it seemed to have become unaffordable for many.

In August 2020, Tesla announced a 5 to 1 split. At that point, Tesla’s share was trading around USD 2200. The day Tesla started trading at the split price, it rose by 12%. This was a clear indication of how attractive the stock had become for many. Today it trades around USD 800.

While Tesla is a new company, older legacy companies have opted for splits several times as well. One of the most famous examples is that of Apple. Apple has carried out stock splits 5 times since being listed in 1980.

Aug 31, 2020: 4-for-1

June 9, 2014: 7-for-1

February 28, 2005: 2-for-1

June 21, 2000: 2-for-1

June 16, 1987: 2-for-1

Hence, while Apple’s stock might relatively cheap at USD 140 today. But it has undergone huge splits and without them would be around 200 times more.

Conclusion

The perception towards stock splits is at the extreme ends. While few consider split to be like bonus shares, few feel splits diminish the value of the stock. As we have determined, it is neither. It is just a process to change the number of shares of a company. It has more to do with psychological and human behaviour than the fundamentals of a company. Hope this explainer has given you clarity and cleared all your doubts about a stock split.

About Alexander Kelm

Alexander Kelm is a passionate value investor and runs the website Wall St. Nerd. Here, the passionate value investor writes in-depth articles on the topic of Value Investing. Value Investing involves analyzing a company's fundamentals and can be characterized by an intense focus on a stock's price, its intrinsic value and the relationship between the two.

Alexander Kelm offers online courses on stock investing.

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