A stock split occurs when a company decides to exchange its shares for more (and sometimes fewer) shares of its own stock, adjusting the price per share so that there is no change in the overall value of the company. Many stock splits are greeted as good news by investors, and shares sometimes rise as a result. However, some splits are perceived as negative and can push the stock down.
Here’s what you need to know about stock splits and why they’re usually not that important.
How a stock split works
When investors talk about stock splits, they usually mean a forward stock split, but that is only one of the two main types of splits. Here’s the simple distinction:
- In a forward stock splityour current shares are exchanged for more shares.
- In a reverse stock splityour current shares are exchanged for fewer shares.
When the split occurs, the stock price also automatically changes to reflect the exchange ratio. That is, regardless of the type of split, you still own the same dollar value of stock as you did before the split. Think of it like cutting a pizza into more slices: the total surface area of the pizza remains the same, you just have more (smaller) slices that make up the pizza.
Here’s an example to show how it works. Imagine you own 100 shares of a company that is doing a 2-for-1 forward split and trading at $100 per share before the split. After the split, you would own 200 shares, but the price would adjust to $50 per share. So you get the same $10,000 dollar value that you had before the stock split.
It’s a similar situation with a reverse split. Imagine you own 500 shares of a company doing a 1-for-5 reverse split and trading at $3 per share before the split. After the split, you would own 100 shares, but the price would adjust to $15 per share. Likewise, you own the same $1,500 dollar value that you had before the stock split.
Most forward stock splits are 2-for-1 or 3-for-1, although sometimes you see a 3-for-2 split. Higher-priced stocks like Apple may offer a higher exchange ratio, as the company did in 2020 with its 4-for-1 split or its 7-for-1 split in 2014.
Why companies split their shares
Companies may split their shares for various purposes, but usually have little to do with the fundamental performance of the company. Typically, a stock is split for some or all of these basic reasons:
- To keep the stock within a typical trading range. Stocks are normally priced between $20 and $120, so companies may want to maintain that convention.
- To make it easier for investors to buy. A lower share price allows investors to buy a stock with less money, but with fractional investing this is less of an issue.
- To increase liquidity. A more liquid stock can lower the bid-ask spread on the stock, making it less expensive for investors to trade the stock.
- To comply with the rules of a trade fair again. A company can use a reverse split to bring its stock price back above a certain threshold, usually $1 per share, in order to remain compliant with an exchange’s rules.
- To increase the stock price. Some large investors are not allowed to buy stocks trading below a certain price, such as $5 per share. So a penny stock, which is often considered risky, can use a reverse split to make its shares more acceptable to these investors.
These reasons for a stock split often have a lot to do with the stock price and the technical aspects of the trade, rather than the fundamental performance of the company. But think about why the stock price is where it is today, and splits also seem to have to do with the company’s fundamentals.
In other words, stocks that go up a lot tend to have forward splits, and they go up a lot because they are growing their profits and pushing the price up. Conversely, stocks that have fallen tend to use a reverse split to bring their price back to a ‘respectable range’, and they are also likely to have gone through a period of underperformance or declining profitability.
So forward splits may indicate that insiders see the stock continuing to rise, while a reverse split may indicate that the stock may continue to fall. It is this show of confidence (or lack thereof) that can help create a self-fulfilling prophecy for the stock undergoing the split, attracting investors who expect the stock to rise (or fall) based on the split and can help make this actually happen.
However, it’s important to remember that the split itself won’t affect the value of your holdings, and the stock’s long-term performance will depend on the profits of the underlying company, not on how the pie is divided.
Why don’t some companies split their shares?
Lately it has become fashionable to build up your stock without splitting it. The best-known example is Berkshire Hathaway, whose Series A stock is trading at nearly $590,000 per share. Other major companies like Amazon and Alphabet have share prices now in the hundreds – previously in the thousands before splitting their shares in 2023, while Apple often has its shares in the hundreds before splitting.
These companies may not split their shares because a lower share price may attract investors who are not long-term oriented and who would rather day trade than own the company. Thus, these companies may favor investors who will not create volatility in the stock and otherwise harm long-term investors who want to benefit from the success of ongoing operations.
Is a stock split good?
A stock split is neither good nor bad, and long-term investors should probably be indifferent to it. They do not affect the value of your investment or the value of the company. However, there are some minor benefits that can come from splitting a company’s shares.
If a stock price rises too much, the price can become a deterrent for new investors who may not be able to afford a share, although brokers who offer fractional shares make this less of an issue. So the split helps make the shares more affordable to more investors and can help increase the stock’s liquidity.
A lower share price also makes it easier for mutual funds and ETFs to own the shares and manage their daily inflows and outflows. Stocks with high share prices can be difficult to manage for funds that want to maintain certain weightings within their portfolios.
Upcoming stock splits
These are some of the companies that have announced plans to split their shares in 2024:
- Walmart: 3 for 1 split
In short
Mathematically, stock splits don’t mean much to shareholders, but they can indicate subtly positive management confidence in the continued rise in the stock price. Ultimately, investors should focus their attention on the company’s performance and its future prospects.
Please note: Bank interest Brian Baker contributed to an update to this story.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
