Have you ever seen the share price of a company decrease randomly? I once saw Google being in the $2,200+ share price range, and then one day it dropped to around $120. I thought Google had taken a big hit and would soon go out of business, but I was very wrong. This phenomenon is called a stock split, and many companies utilize it for many different reasons. Let's take a look.
A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the stock's liquidity. While the number of shares increases, the total value remains the same, because a split doesn't change the company’s market capitalization. Stock splits are often undertaken when a company’s share price has risen to a level that might be too high for many investors to buy individual shares.
How Does a Stock Split Work?
In a stock split, the company increases the number of shares outstanding by issuing more shares to its existing shareholders. For example, in a 2-for-1 stock split, each shareholder will receive an additional share for every share they already own, effectively doubling the number of shares they hold. However, the price of each share will be halved, so the overall value of the shareholder’s investment remains the same.
For example, if a company has 1 million shares outstanding at $100 per share, and it decides on a 2-for-1 stock split, the number of shares will double to 2 million, and the share price will decrease to $50. The total market value of the company remains $100 million.
Types of Stock Splits
Forward Stock Split: This is the most common type, where the number of shares is increased, and the price per share is decreased proportionally. For instance, in a 3-for-1 split, shareholders receive three shares for every one share they own, and the price per share is divided by three.
Reverse Stock Split: This is the opposite of a forward split, where the number of shares is decreased, and the price per share is increased. Companies might do this to boost their stock price if it has fallen too low. For example, in a 1-for-5 reverse split, every five shares are combined into one, and the price per share increases fivefold.
But why exactly do companies decide to undergo a stock split? There are three main reasons including (but not limited to) improving liquidity, psychological effects on investors, and index inclusion.
Regarding liquidity, by lowering the share price, the stock becomes more accessible to a broader range of investors, which can increase the trading volume.
Furthermore, a lower stock price can make the stock appear more affordable or attractive to small investors, even though the value of the investment hasn’t changed. This is how a stock split can be used as a psychological advantage for investors. It seems less volatile and more affordable for all.
Finally, companies might split their stock to make it easier for their shares to be included in certain indices (plural for index), which often have price limits for individual stocks.
It's important to remember that a stock split does not affect the actual value of an investor’s holdings. However, the increased number of shares at a lower price can lead to increased trading activity, which may influence the stock's price in the short term. Additionally, stock splits are often perceived as a positive signal, indicating that the company is growing and confident about its future performance.
Examples of stock splits
Most recently, there was NVIDIA (NASDAQ: NVDA) that went through a stock split. They had a 10-for-1 stock split, and their stock has gone up and succeeded after their split.
Additionally, in August 2020, Tesla executed a 5-for-1 stock split. Before the split, Tesla’s stock was trading at over $2,000 per share, which made it difficult for many retail investors to buy individual shares. After the split, the price was adjusted to around $400 per share, attracting more investors and contributing to increased trading volume.
These examples show how companies use stock splits to make their shares more accessible and potentially enhance trading activity. Learning how stock splits work and how they may affect your investments and trading activity can help you make better financial decisions when it comes to investing in individual stocks.
