What Is a Stock Split, and Why Does It Happen?

Stock splits are unique and often anticipated events by market watchers, traders, and investors alike. This rare and substantial event can be a game changer for the market and the companies involved. So what is a stock split, what does a stock split mean to an investor and why do companies split stocks? 

TL;DR

• A stock split occurs when a company increases the number of its shares while keeping its total market value the same. 

• It makes shares more affordable and liquid without changing the overall value of the company.

• Companies split the stock to increase liquidity, make shares more accessible, and attract more investors by lowering the price per share.

• Investors receive more shares at a lower price, but the overall value remains the same.

• Stock splits are often seen as a sign of a healthy company, but they can also increase volatility in the market

• While shares become cheaper, each individual share’s price is reduced. Stock splits can also increase market volatility, which might be a downside for some traders.

• Reverse stock splits happen when a company consolidates shares to avoid delisting. This can increase the stock price but might not indicate a healthier company.

• Common ratios include 2-for-1 or 3-for-1 splits. The number of shares an investor holds will change based on the ratio.

What Is a Stock Split?

As the name implies, stock splits refer to when companies split their stocks by increasing the number of their outstanding shares. However, although the number of shares outstanding increases, the value of the company remains the same. To better understand this concept, one could refer to the famous saying by Yankees legend Yogi Berra, who said, “You better cut my pizza into four slices because I’m not hungry enough to eat six.” Even though the pizza is cut into more slices, its value as a whole pie remains the same. Accordingly, following the same logic, a company's market cap would remain the same as it was before the split. 

Why Do Companies Split Their Stock?

So why would a company want to split its stock if its value is kept unchanged? Essentially, companies split stocks in order to make them more liquid. Further, stock splits don’t change the stocks fundamentally, instead, they make it easier and more accessible for shareholders to buy. This is because while the value of the company remains the same, a company’s existing shares are broken into multiple new shares without affecting the company's market capitalization or shareholders' equity, all while making the price of the share cheaper. 

How Does a Stock Split Affect Traders & Investors?

If you’re an investor, trader, or simply an inquisitive reader you might at one point find yourself asking “what is the point of a stock split, and what are the pros and cons of splitting stocks?”

First and foremost, when a company splits its stock, it intends to increase its liquidity, which means that it would be easier and also cheaper for investors and traders to buy or sell the stock in question. Traders also get to receive additional shares for every share they own after stock splits. For example, if you’re a trader who owns $100 worth of a company’s share, and a 2-for-1 split occurs, you’ll get ownership of two shares worth $50 each. In other words, you’ll get to buy stocks for a cheaper price while owning more stocks than you originally did (for the original price you paid). (Source: CNBC)

Moreover, stock splits are generally a good indicator of a healthy company because it usually means that the company splitting its stock is a good investment. 

What Are the Disadvantages of a Stock Split?

On the other hand, stock splits are not black or white and do have some drawbacks. One more obvious disadvantage of stock splits is that while stock splits give investors more shares of the company as well as make the shares more affordable, it also means that your existing share would cost less. In addition, stock splits can also increase market volatility. This is because stock splits bring forth new stock prices, which means that more investors may tend to purchase the split stock, which, in turn, can increase volatility. This aspect may be viewed by some as a plus, while to others, it might seem like a burden. (Source: The Balance Money)

What Is a Reverse Stock Split?

In addition to the aforementioned potential drawbacks, it is important to note that stock splits don’t always occur when companies are healthy or worthy of investing. In some cases, such as like in “reverse stock splits,” companies do it in order to avoid having their stock delisted. After a reverse split, some investors may see the stock price rise, but the stock may not increase in value, or it may take a long time to recover.

Stock Split Ratios

Stock splits can happen in different ratios. However, two-to-one and three-to-one ratios are the most common split ratios. Bear in mind that the number of shares each stockholder holds before the split will determine the number of shares they will hold after the split. 

Recent Notable Stock Splits

Some of the recent stock splits over 2022 are Alphabet (GOOG), Amazon (AMZN) and Tesla (TSLA). As mentioned above, stock splits do not always solicit a rise in the stock price. Take, for example, tech giant Alphabet, which split its stock on July 15th, 2022, by a 20-for-1 ratio. After the split came to fruition, the company’s shares went through a price rollercoaster, perhaps driven by higher interest rates and inflation. This may be because investors usually tend to shy away from tech stocks and opt for more inflation-proof safe-havens. In the first 12 days after the split, the company’s share rose by 2%. (Source: The Motley Fool)

Conclusion

Stock splits are a strategic move by companies to make shares more accessible and liquid, which can potentially benefit investors by increasing the number of shares they hold. However, while the split lowers the price per share, it does not change the overall value of the investment. As with any market event, stock splits have both advantages and drawbacks, and their impact depends on market conditions and investor sentiment.

FAQs:

What happens to the price of my stock after a split?

The price of your stock will decrease proportionally, but the total value of your holdings remains the same. For example, if you owned one share worth $100 and a 2-for-1 split occurred, you would have two shares worth $50 each.

Are stock splits always a good sign for a company?

Not necessarily. While stock splits are often associated with growing companies, they don’t always guarantee future performance. Some companies, especially in troubled financial conditions, may use reverse stock splits to avoid delisting.

What is a reverse stock split?

A reverse stock split is when a company consolidates its shares to reduce the number of outstanding shares. This typically happens when a company's stock price is too low, and the company wants to avoid delisting or maintaining a certain stock price level.

Will a stock split make me more money?

A stock split doesn’t directly increase your total value or make you more money. It only makes the shares cheaper and more accessible to new investors. However, stock splits can sometimes lead to short-term price movements due to increased trading activity.

What is the typical ratio for stock splits?

The most common stock split ratios are 2-for-1 and 3-for-1. However, companies can choose different ratios based on their strategy.

Do stock splits impact dividends?

In general, the total dividend payout is adjusted post-split. For example, if a company pays a $1 dividend on one share after a 2-for-1 split, it would pay 50 cents per share on each of the two new shares you own.