What a Stock Split Means for Your Holdings

What Is a Stock Split?

A stock split occurs when a company divides its preexisting shares into multiple new shares. In doing so, a stock split also effectively reduces the share price. However, a stock split is a neutral action, meaning that it does not increase or decrease the market capitalization. Rather a stock split aims to increase liquidity.

Market capitalization, often referred to as simply market cap, is the market value of a publicly traded company and can be computed by multiplying the share price by the number of shares outstanding. Liquidity refers to how easily assets, such as stocks, can be converted to cash. 

A reverse stock split can be used to decrease the number of shares outstanding a company has, instead of increasing the number of shares. Thus, a reverse stock split effectively increases the price of an individual share while not affecting the market cap.

How Do Stock Splits Work?

Stock splits are initiated by a company’s board of directors, who identify to what extent either a stock split or a reverse stock split would be a useful tool. 

Reasons that a company would consider a stock split

• To attract a wider range of investors: A company may decide to carry out a stock split in order to attract more investors, especially if its stock price has become expensive. Since a stock split reduces the price tag on an individual share, it becomes more affordable for investors, especially those who could have originally been deterred by the expense.
• Competition: A company may look at its competitors and realize that its shares are more expensive than theirs. By initiating a stock split, a company can encourage investors to choose its own stock over competitors by lowering the price of its existing shares.
• Liquidity: A stock split can increase the liquidity of a company’s shares. Since a stock split increases the shares outstanding and decreases the share price, common stock investors are incentivized to buy. In turn, the bid-ask spread, or the difference between the sale price and the highest price at which a buyer will pay, narrows. When demand is high for a company's stock, there is more market activity which allows the stock to more easily be converted into cash.
• Sign of strength: Lastly, a stock split shows that a company is performing well because its stock has gotten expensive enough to need to split it. Just the announcement of a stock split can turn investor’s heads and incentivize them to buy a stock.

Reasons that a company would consider a reverse stock split

• To meet a minimum to remain on an exchange: Stocks can be delisted from an exchange, such as the New York Stock Exchange (NYSE) and the NASDAQ, if they do not meet the exchange’s requirements. Companies must meet a given exchange’s listing standards: one of which is pricing. For example, say a company has a share price under $1 for a period of months. It may find itself at risk of being delisted from the exchange, but if it undergoes a reverse stock split, it can raise its share price and put itself back in a position to remain on the exchange.
• Attract investors: Similar to the point made above, a company can undergo a reverse stock split to increase the market price of its stock in hopes of attracting investors who would be willing to pay more for its shares. This is not as popular as making shares more affordable via a stock split, but it is still a useful tool for a company’s board of directors to have in their back pocket just in case they are looking to attract a specific type of investor. 
• Increase the perceived value of the company: A company may choose to undergo a reverse stock split to increase the perceived value of its operations. In general, investors will compare companies in similar industries, and having a higher share price may signal a better value.

A deeper look at stock splits

Once the board of directors decides what they want to achieve via a stock split, they must decide on the split ratio. Popular stock split ratios are 2-for-1, 3-for-1 and 3-for-2. To take 2-for-1 as an example, this notation means that for every former stock, it now is split into two. Now that the split ratio is determined, the price of shares adjusts automatically in the stock market.

Now, post-split, the stock’s price has changed. It has either decreased as a result of a stock split, or increased as a result of a reverse stock split. However, to reiterate, the value of the company stays exactly the same.

An Example with Apple

Apple (AAPL) provides a great example of how and why a stock split takes place. Since its initial public offering (IPO) in 1980, it has undergone 5 stock splits. It had a notable split on August 28th, 2020. Apple stock was split on a 4-for-1 ratio, which effectively quadrupled the number of outstanding shares. Pre-split, each share was trading at around $540. Post-split, the price per share was $135. This can be seen as an advantageous move for Apple because it was able to attract more investors while also signaling strength. 

As noted before, 2-for-1, 3-for-1 and 3-for-2 stock splits are more popular, so Apple’s 4-for-1 split was uncommon. However, a larger split ratio has been increasingly popular among tech giants such as Apple and Tesla.

Implications of Stock Splits

So, what happens if you own stock in a company that decides to implement a stock split? Nothing really. As mentioned before, you will now own more shares of that stock, or less if we are observing a reverse stock split, but the value of what you own will remain the same. In addition, there is no work that you have to do as the stockholder; rather, a brokerage firm will automatically make this adjustment within your portfolio. 

Focusing on just stock splits for the moment, a key concept we have learned is that a stock split does not increase the value of a company. In other words, a stock split is a neutral corporate action. However, by signaling steady growth and decreasing individual share price, this oftentimes leads directly to more interested investors. More investors can lead to the eventual growth of a company, and increased value in your personal holdings in the future.

A note of caution would be that a stock split can signify that shares of stock are doing well, but it does not mean that this good performance will endure indefinitely. As always, it is important as an investor to do your own research and be aware of how current events can determine market behavior.