What are stock splits: Stock splits are a natural part of the investing game. While many people ascribe a lot of importance to them, they are really just a normal part of a company’s financial management.
Here’s how they work:
- Company as legal structure: A company is merely a legal structure of shares and owners of those shares. Of course, each one of those shares has a value attached to it and the company’s overall value (called its market capitalization) is the total value of the company is the collective value of all these shares (# shares * value of each share)
- Share value: A company’s shares fluctuate in value, rising and falling according to investor expectations.
- Stock splits: When a company (actually, its Board of Directors needs to vote on it) wants to bring in new investors or if it believes its stock price has gotten too high, it can split its shares, issuing additional additional shares.
- Number of shares increases, not value of company: Stock splits merely increase the share count of a company, not its value. So, if a company has 1 million shares value at $50 a piece and does a 2-for-1 split, there will now be 2 million shares at $25 a piece. Simple arithmetic (though, sometimes a company will do something wacky like a 7 for 2 split or something)
That’s the simple case. Let’s explore why a company would want to split its stock.
Why companies split their stocks
Companies can split their stocks for a variety of reasons.
- Attract a new, diversified investor base: Stocks like Berkshire Hathaway ($114,000) and Apple ($400) clearly haven’t split their stock in some time. That’s on purpose – both firms have courted serious, long-term investors who must pony up some major cash to invest in them. Other firms, focused on bringing in a more diverse shareholder base, split their stocks to make owning 100 shares of their firms more realistic.
- The reverse stock split and mutual fund stock ownership: For all sorts of reasons, companies need to raise additional capital. This fund-raising can increase a firm’s share count, diluting the value of the shares as additional shares are issued to new investors. After a while, a small company can have tens of millions of shares outstanding priced extremely low (like penny stocks). Mutual funds are typically prohibited from investing in stock priced below $5. So, if a company wants to attract large investors, instead of issuing more shares, these firms reverse split their stocks. This consolidation means that there are less shares outstanding and each share would be worth incrementally more. So a company with 10 million shares outstanding worth $3 a piece would have 5 million shares outstanding at $6 a piece after a 1-for-2 reverse split.
- Juice the stock price: While the research doesn’t necessarily bear this out, many firms (and investors!) mistakenly believe that stock splits somehow increase the value of a firm (well, I had 100 shares of the stock and now, after the split, I’ve got 200!). So, companies looking to inject a little positive momentum into their stock prices, split their stocks hoping for a little boost. Maybe investors just feel wealthier with more shares in their portfolios or maybe it’s just an old wives tale, but a stock split doesn’t increase the total value of a company. While there isn’t evidence that prices necessarily go up after, splits do seem to create more liquidity for the stock.
Can you exploit splits?
Well, yes and no. There doesn’t seem to be any real proof that stocks go up after a split — stock prices are viewed as independent from their performance. But that’s not exactly true.
In Is Share Price Relevant?, two researchers found that generally, stocks priced under $5 and over $20 perform differently. In fact, if you created a portfolio that bought stocks under $5 and sold short stocks priced over $20, the return on this portfolio would beat the market by about 15% per year. That’s a huge return.
So, investors who wanted to play stock splits could do so in tandem with looking for stocks whose new prices were reset to below $5.
Stock splits happen frequently and while investing lore believes prices go up afterwards, the research doesn’t necessarily find this to be the case. Regardless, splits are a useful tool for company management to bring in new investors.