What Is a Stock Split - The Inside Scoop
Stock splits are often part of a strategy for publicly traded companies. There are famous examples of splits, and they're usually considered a predictor of good things to come for investors in a particular stock. So let's look deeper at the question: What is a stock split?
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What Is a Stock Split?
A stock split is a maneuver sometimes employed by companies that increase their total number of shares available without affecting the company's overall valuation.
This maneuver reduces the value of each stock share because there are more total shares resulting from the split. But each investor ends up owning shares with the same value in total.
How Does Splitting Stocks Work?
Stock splitting might sound complicated, but it's relatively simple. When a company performs a split, they issue more shares, but the total value doesn't change.
For example, consider a company with fifty total shares and a $50 valuation. You own 25 of them, each valued at one dollar.
When the company does a two-for-one stock split, the total pool of shares increases to 100, and you now own 50. While the number of shares doubles, the value of each splits in half.
As a result, your 50 shares are each worth $.50, there are 100 total shares on the market, and the company's valuation holds steady at $50.
Reasons for Stock Splits
Why would a company want to split its stock? Usually, the goal is part of a strategy to create liquidity. When the value of shares splits, it makes the stock more appealing to investors, as it costs less per share.
Example
In 2020, one of the biggest companies in the world, Tesla, underwent a 5-1 stock split. Overnight, costly shares traded at about $2,300 each became five shares, with a value of around $450 each.
This split made the stock more affordable for investors, great and small, and almost immediately led to another 12.5% surge in the company's overall valuation.
Tesla isn't the only company that has split in recent years, as Apple undertook a 4 for 1 split around the same time. It had a valuation of around $500 per share.
After the split, the stock was trading at around $120 each. Similar to Tesla, Apple stocks were buoyed by a surge in buying, and there was a surge in the value of the company and individual shares.
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What This Means for the Average Investor
For the ordinary investor, splits typically mean an opportunity to make money, balanced against the risk of losing it. In both our examples, an investor could have profited by investing before or after the split. But no one can foresee the future.
What often happens is that the reduced per share price post-split triggers a surge in purchasing, many times because investors seek diversification of their portfolio. But, the increase in value isn't always sustainable, and it's no sure bet that your shares will hold their worth.
It's essential that any stock purchase you make (or any sales you perform) aligns with your overall investment strategy, with an eye toward a diversified, healthy portfolio spread out over different asset classes.
Your portfolio shouldn't focus on questions like, 'Can stock purchases make me money?' Instead, it would be best to concentrate on diverse streams of investment in various mediums.
Stock Splits vs. Reverse Stock Splits
A reverse stock split is essentially the reverse of a traditional split. Instead of increasing the number of shares and reducing their individual value, a reverse stock split sees a company reduce the total number of outstanding shares, raising each share's market value.
Types of Stock Splits
Stock splits come in many forms, but there are some common ratios. Let's consider a common starting place, where a supposed company has 100 original shares outstanding.
2 for 1
In a 2 for 1 split, our hypothetical company with 100 shares outstanding will end up with 200 total shares.
3 for 2
In this less common but not rare stock split ratio, the company increases its outstanding shares by half, and each shareholder ends up with three shares for every two they held before the split. So, in our 100 share example, the total number of shares outstanding moves to 150. An individual shareholder who had ten shares would have fifteen post-split.
3 for 1
A 3 for 1 split would have our hypothetical company with 100 shares end up with 300 shares outstanding.
4 for 1
A 4 for 1 split would have our 100 share company split into 400 shares. The overall valuation of the company remains the same.
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Stock Split Pros
Stock splits have certain advantages and upsides for both shareholders and companies.
- Increases the potential pool of investors
- Makes the stock more affordable to a broader range of investors
- Reduce capital costs for the company (by narrowing the gap between bids and offers)
- Offers weighting advantages for indexing benchmarks
- May boost a company's valuation if there is buying enthusiasm
Stock Split Cons
Stock splits also have some negatives for both shareholders and companies.
- Manipulating the number of shares may see a company fail to meet indexing requirements
- Short-term gains are often temporary
- Fractional shares may make stock splits unnecessary
Stock Split FAQ
Some questions come up all the time about stock splits.
What Happens if I Own Shares That Undergo a Stock Split?
You will receive additional shares corresponding to the ratio of the split. Or, if it's a reverse split, your total shares would drop, according to the ratio. The ownership, mechanics, and valuation of the company all remain the same.
Will a Stock Split Affect My Taxes?
Stock splits won't affect your tax liability unless you sell shares and earn capital gains. However, some politicians are trying to craft changes to the tax code that would see investors pay taxes on unrealized capital gains.
Are Stock Splits Good or Bad?
Stock splits are neither good nor bad, but they can signal good things to come for a stock. It's all about generating investment enthusiasm.
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Does the Stock Split Make the Company More or Less Valuable?
The company's valuation doesn't change when the stock splits—only the number of outstanding shares changes. But, in the aftermath of a split, market action around the stock may reverse its valuation.
How Do Stock Splits Affect Short Sellers?
Typically, stock splits don't affect short sellers because brokerage houses will adjust orders to account for the split.
Key Takeaways
The stock market can seem overwhelmingly complex. There is a lot to learn about a company's stock, stock price, underlying value, market capitalization, and more. Here at Myra, we believe in helping our clients make finances easy.
So whether you need us to define 'share,' or you want to discuss stock splits coming up or how to maintain a stock split calendar, turn to our advisors.
When you need to demystify murky concepts like taxes and investments, we're your best resource. Consider consulting with one of our financial advisors today.