Key takeaways
- Stock splits divide a company’s shares, creating more shares and lowering the stock’s price.
- This can help increase the liquidity of shares.
- Nothing about the underlying company changes, but splits are usually seen as a positive indicator.
If you follow investing news, you might hear people talk about a company going through a stock split. Stock splits are a common strategy for businesses that want to increase their liquidity, making it easier for people to buy and sell shares by making those shares less expensive without impacting the company’s overall value.
Here’s what you need to know.
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What is a stock split?
A stock split allows a company to change the number of shares that exist in a company without having to issue new shares. Instead, the company splits existing shares (hence the name) into multiple shares. For example, in a 2-for-1 split (sometimes described as 2:1) each share will become two shares.
Typically, all other aspects of the stock also get split when the split happens. If a company pays a dividend, the dividend will be lowered by a ratio corresponding to the split. The stock price also changes.
To illustrate how this plays out, imagine you own 10 shares in a company that undergoes a 2:1 split. Each share is worth $100 and pays an annual dividend of $1. After the split, you’ll own 20 shares, each worth $50 and paying an annual dividend of $0.50. So even though the configuration changes, the value of your investment remains the same as a result of the split.
Splits can happen in any ratio, though 2:1 or 3:1 are among the most common. However, irregular splits like 5:3 or similar aren’t unheard of. There are also reverse stock splits, where companies turn multiple shares into fewer, such as a 1:2 split which turns two shares into one.
Why do companies split their stocks?
Companies split their stocks for many reasons. One of the most common is to increase liquidity, by making it easier for people to trade shares.
Imagine a stock that trades at $1,000 per share. Many investors would struggle to come up with that much to invest with. It would also be hard to allocate a precise amount to an investment in the stock because you can only invest in $1,000 increments.
A 20:1 split would result in the company having a share price of $50, making it far easier for everyday investors to buy in.
Another common reason for a stock split is that it can entice investors and make a company’s shares more attractive.
Theoretically, nothing about a company changes when it undergoes a stock split. It’s simply a paper change to the number of shares outstanding and the price of those shares. However, stock splits usually occur when a company’s share price is high.
Investors typically conflate high share prices with a successful company. That leads to the perception that a company is doing so well that it has to split its stock to remain affordable and that it must be a good investment opportunity. In many cases, companies will see a spike in share prices after splitting their stock.
Reverse splits
Reverse splits (turning more shares into fewer) often happen for slightly different reasons than typical splits.
For example, a company may use a reverse split to pump up its per-share price, which may be a requirement to remain listed on a certain stock exchange. For example, NASDAQ requires that companies maintain a minimum price of $1.
Reverse splits to increase price can also help a stock avoid falling to such a low price that it gets perceived as a penny stock.
Disadvantages of stock splits
Not every company likes splitting its stock, and there are a few reasons for that.
One is that stock splits don’t really change anything about the business, and they can come at a regulatory cost. The company has to pay for all of the legally-required filings and the paperwork involved with adjusting the number of shares that exist.
Another reason is that high share prices are a selling point for some companies. Tech companies looking to show explosive growth might not want to use a stock split to slash their per-share price because the high price helps show their success.
What happens after a stock split?
In theory, stock splits should have little impact on a company. Beyond small changes to the liquidity of shares, nothing is altered about the underlying business. You’re simply taking what was already there and dividing it into a different number of shares than you did previously.
Investors who already hold shares in the company don’t need to do anything or worry about splits happening. They’ll simply wake up on the day of the split to find their holdings adjusted accordingly.
However, the market often reacts to news of stock splits. Investors often perceive splits viewed as a positive sign for a company, which can lead to a spike in its stock price.
For example, in March 2022, Amazon announced a 4:1 stock split. It traded for (a split-adjusted) $145.64 per share at that time. Over the next weeks, it spiked to a bit more than $169.
On the other hand, investors usually perceive reverse splits as a negative. In many cases, companies undergoing reverse splits see share prices fall.
What a stock split means for investors
For most investors, stock splits aren’t a big deal. If you already own shares in the company going through the split, you don’t have to do anything except wait for the split to occur and the number of shares in your brokerage account to adjust.
The main thing to pay attention to is how the split impacts investor sentiment. Usually, splits are a positive indicator and reverse splits are a negative one. You could use that information to try to trade stocks expected to announce splits or about to go through a split.
However, keep in mind that the underlying business isn’t actually changing, so you’ll be trading on sentiment rather than fundamentals.
The bottom line
Stock splits let a company manage its share price by dividing shares into multiple pieces or combining multiple shares into one. Most of the time, they’re not much for investors to worry about.
When investing, keeping track of a company’s fundamentals and things like stock splits can be difficult. If you’re looking for help, consider using Q.ai. Its artificial intelligence can design a portfolio for any goal or economic condition. With Investment Kits, investing can be easy and fun.
Download Q.ai today for access to AI-powered investment strategies.
