One thing I often read about is stock splits. Recently Amazon, Tesla, and Apple went through stock splits. So far it has been very positive for their investors.
In today’s age of computers and electronic trading, stock splits can occur automatically, but the announcement can have a substantial impact on your investment strategy.
Typically, companies announce stock splits when share prices are rising,
So what is a stock split?
Any company that is publicly traded will have a certain number of outstanding shares. When a company’s board of directors meets or (bylaws are triggered) to increase the number of shares that are outstanding by issuing more shares to current shareholders, that is what is known as a stock split.
In the case of stock splits, dividends are recalculated to reflect the new share count, but the total amount of payout doesn’t change. If you own options on a stock, the adjustments are made automatically in your account.
As an example, if a company was to do a 2-for-1 stock split, each shareholder is given an extra share for each share he holds.
So now, if a company had 8 million shares outstanding before the said split, it would now have 16 million shares.
This will also affect the price since the number of outstanding shares has increased. In the example before, each share will cost half as much as before. So even though there are more shares for a company, the halving of the share price means the market capitalization remains constant.
Investors react positively to stock splits
Despite the fact that stock splits are costly corporate decisions that do not change the fundamentals of a firm, the stock market often reacts positively to announcements of them.
In fact, studies spanning the last 40 years have examined the phenomenon of stock splits and the positive reaction of investors to them. According to the studies, a firm’s stock price is often undervalued before the split and is most overvalued in the year of its announcement.
Stock splits tend to be positive for shareholders as they reduce the total number of shares in a company. Stock splits may also improve liquidity and index inclusion. They may also signal positive information about future dividends or earnings. In addition, they explain why stocks react positively to other information. In particular, research by UNSW Business School Associate Professor Mark Humphery-Jenner has revealed the positive reaction of investors to stock splits.
The effect of stock splits is often described as “an announcement effect,” which occurs when an announcement precedes the actual event. As soon as the split announcement is made, a chain of events begins.
The number of transactions is increased, while the raw volume of shares traded decreases. The increased volume and noise increase the tax-option value of the security, which contributes to the positive stock split effect. Moreover, this phenomenon is the same for the behavioral effect of stock splits.
If a company announces a stock split, it signals that the company board is looking to attract investors. This increase in the availability of shares can lead to a handsome portfolio benefit. In addition, stocks that undergo stock splits often outpace the broader market the year of the split and even over the subsequent years. It is important to note that, after a split, shareholders have to remain shareholders for that specific date.
A stock split also improves the liquidity of a company. A company with 100 crore shares outstanding recently announced a stock split to a face value of Rs two. That means that a shareholder who owned one share before would now own two or three shares. The effect is even greater for those holding fewer than 100 shares. Likewise, a company that has underperformed its peers is likely to be able to attract new investors.
They increase liquidity
Companies often consider stock splits to increase their liquidity by increasing the number of outstanding shares. By increasing the number of shares outstanding, a company can increase the number of available options to trade the stock, narrowing the bid/ask spread and allowing new investors to buy more shares at a lower price. Stock splits increase the number of shares available for existing shareholders, too, thereby boosting liquidity and enabling companies to repurchase shares at a lower price.
A stock split can have several positive effects. Stock prices rise as a result of the increased liquidity. It also narrows the bid-ask spread, making trading easier. This in turn results in more flexibility for investors. In the long run, this can lead to a positive stock price. Moreover, it also promotes good business perception among investors. In the long run, stock splits can help increase the value of a company.
In addition to lowering a company’s stock price, a stock split can help increase its liquidity. It does not affect existing shareholders’ ownership positions. Existing shareholders will still own more shares than before. Unlike other types of splits, a stock split will increase the number of shares available for sale. In the short run, stock splits will help increase liquidity. The benefits of a stock split include:
A stock split can also reduce the cost of investing. Investors who are buying shares of a company may find the price more affordable if a stock split occurs soon after they bought it. But before making the decision to purchase a stock, it’s important to research the company. After all, this is an important part of investing. The more you know about the company, the more likely you will be to invest in it.
Although stock splits don’t create value for the company, they may provide a much-needed infusion of capital to a struggling company. The influx of capital can help improve a company’s business, which will boost its stock prices. It also increases the overall liquidity of a stock because it’s more accessible to smaller investors. As a result, more investors will buy the stock, which in turn leads to greater trading volumes and overall liquidity.
They increase wealth
While stock splits increase wealth, they can also be a source of motivation for buyers. For example, a stock split may encourage people to purchase shares of a company if it’s expensive, but it also gives a boost to its price if more people buy it. Stock splits also help companies convey confidence in the value of their stock by encouraging a wider range of investors to purchase shares. However, with the rise of fractional investing, stock splits are less relevant.
A stock split may not lead to even fractional shares, but it will certainly increase your wealth. Reverse splits, on the other hand, are not as risky and can also boost your returns, as investors tend to buy shares in an even number. In addition, some investors prefer to pay an even price for shares instead of getting a fractional share, as reverse splits are known as ‘cash in lieu’ transactions.
CEOs are also busy buying stocks around stock split announcements. Compared to the previous year, the CEO trading around a stock split announcement increases four times. Moreover, two-thirds of CEOs purchase stock before the announcement, while a similar number sell it afterward. This means that the average CEO ends up $345,613 richer following a stock split than they were before the announcement. The study’s authors conclude that this opportunistic behavior is not unique to firms.
While this study is limited to the Indian market, it shows that stock splits increase wealth for many investors. Historically, a one-for-five stock split, for example, allocated five shares to each shareholder, lowering the quality of the offer by one-fifth of the previous quality. While these are not the only cases of stock splits increasing wealth, they are certainly worth considering. This study also shows how stock splits affect money-related ratios.
They don’t affect a company’s value
While stock splits do not decrease a company’s value, they can make the shares more affordable for smaller investors. They can also help attract new investors, whose purchases will push up the prices of stock. Despite their temporary effect, stock splits can be newsworthy events. For instance, a 20-for-one stock split announced by Amazon resulted in an increase of $20 per share, or $2.44 for each share. While stock splits don’t lower a company’s value, they can increase it because the process of buying shares is more convenient for smaller investors.
When a company announces a stock split, its shares are issued at a lower price than they were original. However, this merely changes the structure and count of the company’s shares. Short sellers may not have any effect on the value of their portfolios, and their short positions will not change. Instead, their short positions will have the same value as they did before the stock split, as the new number of shares issued by the company has been reduced.
A stock split, on the other hand, is an act of a company’s Board of Directors to signal to new investors to buy the company’s shares. It is therefore important to understand the appetite of different investors in your industry, as well as their risk appetite. For example, a company may have ten million shares that are worth $0.50 cents each. The reverse split would reduce these shares to two million shares at $2.50 each, but it would still be worth $5 million.
While stock splits don’t affect a company in terms of the value of its shares, they can impact psychological behavior. For example, a stock split may encourage some investors to buy a company’s stock, whereas a low share price can discourage others from buying. If a company’s share price increases after a stock split, it may make new investors think the shares are unaffordable. A stock split may therefore help a company increase its value over time.
Why do Companies Split Stocks?
A company usually splits its stock once its share price increases to such a level that is too far above the price levels of other companies in the same sector. The biggest draw to stock splitting is to make shares look more reasonable to smaller investors, even though the value of the company hasn’t changed. This, in practical terms, increases the liquidity in the stock.
And once this stock split happens, the share price can increase right after a decrease. Since the stock is more affordable and more alluring to smaller investors, they end up buying stock and driving the prices up by driving demand up. This is helped by the fact that since stock splits are done in a response to higher prices, investors believe the growth will continue in the future.
For one real-world example, let’s look at Apple. Back in June 2014, Apple Inc. split its shares a whole 7-for-1 to allow more investors to access the stock. Looking at the numbers, before the split, Apple’s share’s opening price was about $649.88. After the split, each share was worth around $92.70 (648 ÷ 7).
Existing shareholders had their amount of shares increase seven-fold, which means an investor with 5,000 shares of AAPL pre-split would have 35,000 shares post-split. The total number of shares Apple had outstanding went from 861 million to 6 billion shares!
This, of course, didn’t affect the market cap at $556 billion. At least, not until the day after, when the prices for the stock increased to$95.05 to reflect the increased demand.
Is there a Reverse Stock Split?
Of course, if a company’s share prices are too low, which can cause a company to be delisted (many stock exchanges will delist stocks if they fall below a certain price), or if a company just wants to gain respectability in the market, a company can do a reverse stock split, which is exactly what the name describes.
A reverse stock split will combine stocks together to make each share worth more. As an example, if a company does a reverse 1-for-3 split, 3 million outstanding shares at $1 per share would now become 1 million outstanding shares and a price point of $3 per share. The company is still worth $3 million, not affecting the current price for the moment.
As another real-life example, let’s use Citigroup. In May 2011, the company did a reverse stock split, going for a 1-for-10 in an effort to reduce share volatility and discourage some of the speculator trading that had been going on. This changed Citigroup’s stock price from $4.52 to $45.12 post-split, and every 10 shares held by an investor turned into 1 share. While this changed the number of shares outstanding from 29 billion to 2.9 billion shares, Citigroup’s market cap stayed at about the same at around $131 billion.
What About Short Selling?
Worry not short sellers, stock splitting does not affect your decisions in a material way. Though some changes do happen to your portfolio, the value is still the same. The only things that change are the number of shares being shorted, and the price per share. When an investor decides to short a stock, they are simply borrowing the shares and will have to return them somewhere down the line. Let’s create a hypothetical investing situation.
Bob the investor shorts 50 shares of ABC Corp. for $30. At some later point, they will be required to return those 100 shares back to the lender. If the stock happens to take a 3-for-1 split before the shares are returned, all that changes is that the number of shares that Bob needs to return have tripled.
This hasn’t changed the value of the total number of shares Bob has, either. If each share was original $60 dollars, once they split each share is now worth $20 dollars. Looking at the math, it doesn’t matter whether or not Bob has 50 shares priced at $60, or 150 shares priced at $20 dollars, as the total amount ends up at $300 total either way.
Now, originally Bob only owed 50 shares. But since the shares split 3-for-1, Bob owes 150 shares. This hasn’t changed the costs or anything, however, which means this hardly affects Bob. If Bob closed the position after the split, they will buy 150 shares in the market for $5 and return them to the lender. Bob comes out with a profit of $750 (money received at the short sale ($30×50) less the cost of closing out the short position ($5×150). That is, $1,500 – $750 = $750). The entry price for the short was 50 shares at $30, which is equivalent to 150 shares at $10. So the short made $5 per share on the 150 borrowed, or $15 per share on 50 shares borrowed if Bob had sold before the split.
Stock splits are really quite simple once you get down to it. A company does a stock split when their price per share has gotten too high, either for their usual investors or for their current field of companies. Although the amount of shares increases, and the price of a share decreases, the market capitalization, and more importantly, the value of the company, stays the same. This means that small investors now have a chance to invest in more companies, and the companies have greater marketability and liquidity in the market! Win-win!