What is a Stock Split and Why do they Happen?

What is a Stock Split and Why do they Happen?

Any company that is publicly traded will have a certain number of outstanding shares. When a company’s board of director meets 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. 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 said split, it would now have 16 million shares. Investors have been asking if Amazon stock or Google stock will split. This will also affect the price, since the number of outstanding shares have 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.

Why do Companies Split Stocks?

A company usually splits their stock once their 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 it’s shares a whole 7-for-1 to allow more investors to access 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.

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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 amount of shares outstanding from 29 billion to 2.9 billion shares, Citigroup’s market cap stayed at about the same ata 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 originally $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 short sale ($30×50) less cost of closing out 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.

For Review

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 increase, and the price of a share decreases, the market capitalization, and more importantly, the value of the company, stays the same. Which 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!

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