Should I Be Happy About Stock Splits?

Astock split may sound like trouble if you’re unfamiliar with the term. However, you shouldn’t let it intimidate you, as investors can actually enjoy a few advantages from a company’s decision to split its stock. Understanding stock splits can help you feel more confident when this occurs.

  • A stock split is when a company divides the number of shares that are available, dividing the price by that same number to make the shares more affordable.
  • A reverse split is when a company reduces the number of shares to raise the price, usually to avoid the risk of being delisted from the exchange.
  • While a stock split shouldn’t have any impact on the value of shares, studies show that, historically, the price per share tends to go up when a company executes a stock split, as it’s an indicator of company strength, which increases investor confidence.

What Are Stock Splits?

Image via Unsplash by Nick Chong

A stock split is when a company’s board of directors divides an individual share into multiple. All companies that are publicly traded have a set number of outstanding shares. When a board decides to execute a stock split, they’re increasing the number of outstanding shares and issuing more to the current shareholders.

Understanding Stock Splits

C ompanies may choose to split their existing shares into multiple so they can lower the price that a stock is trading for on the market. The goal is generally to make the stock more affordable. For example, most traders are more comfortable with the idea of buying 100 shares of a particular stock for $10 rather than spending the same amount of money to buy 10 shares of stock that’s trading at $100 per share.

If a company’s share price has increased, the company may choose to split its shares to get the shares back down to a price that investors are more comfortable trading. When this happens, the price on the market automatically adjusts.

The board of directors for the company can choose to split the stock in any one of a number of different ways. Depending on the current price, they could split it in half, into three for one, five for one, or even 100 shares for one. In other words, for every one share that an investor owns, if the board split the shares 100 for one, an investor who owned 100 shares would suddenly own 10,000. However, the price per share would be reduced by the number of ways the stock is being split.

Of course, a company doesn’t want the price of its shares to reach the other extreme either. If a stock is trading for only a few dollars per share, reaching the penny stock range, it can fall off the radar screen for institutional investors.

If the prices fall too low, the company could risk being delisted from the exchanges entirely since most have certain price requirements companies must meet in order to maintain their listing.

Reasons Companies Carry Out a Stock Split

Reduce Share Prices So They’re More Affordable

The primary reason that a board of directors might choose to split stock is if the price per share is extremely high, making it expensive for an investor to acquire the standard 100 shares. For example, Apple stock rose to almost $700 per share back in 2014, a price that was too high for the average investor. Buying 100 shares of the stock would cost nearly $70,000. The board of directors chose to execute a split stock, dividing it seven different ways so that the stock could trade for a more affordable $92 per share.

Increase the Liquidity for the Stock

Liquidity refers to how quickly shares of a stock can be bought or sold without impacting the price of the stock. If a stock has low liquidity, it can be hard to sell when you’re ready. This could force you to take a bigger loss than you might otherwise have if you can’t sell the shares when you want to. If a company can increase the liquidity of a stock, it encourages trading and can narrow the bid-ask spread.

Make Selling Put Options Cheaper

A stock option is a contract that gives an investor the right to buy or sell shares of a particular stock at a specific price and within a specified frame of time. A put option, specifically, gives investors the right to buy shares of stock. Investors typically buy puts if they are bearish and think that the price is going to drop. They want to lock in a higher price per share.

If you’re buying put options, the only risk you incur is the cost of the premium that you pay for the option. If you’re selling, also called writing, put options, your risk is much greater. If something catastrophic happened in the market or with the company, the price of the shares could technically drop as low as zero.

Regardless of the price of the shares, the options contract seller needs to be prepared to purchase 100 shares (the number of shares typically included in options contracts) at the strike price. If a stock is trading at $1,000 per share, the seller would need to have $100,000 available to fulfill the obligation to purchase the stock if the buyer exercised their option. On the other hand, if the stock was trading at $20 per share, the seller would only need to come up with $2,000 to buy the stock.

Increase Share Prices

Another reason companies sometimes choose to split stocks is that it can actually increase share prices. While the act of splitting actually doesn’t increase the value of the company (it just increases the number of shares that are available), if you analyze stock splits, you’ll see that even the announcement of a split tends to be accompanied by a stock price increase.

Advantages of Split Stocks for Investors

It’s important to keep in mind that the execution of a split stock doesn’t automatically have any impact on the value of the company. In other words, slicing the shares into smaller pieces doesn’t automatically make the cake bigger. However, a split stock isn’t completely useless either. By splitting the higher-priced stock into more shares at a more affordable cost, it makes the shares affordable for more investors.

A split stock execution also is a positive signal from a company’s board of directors that its corporate prospects are strong. As mentioned above, stocks tend to perform better immediately after a split. While, in theory, the split shouldn’t have any impact on the price of the stock, what often happens is that investor interest is renewed.

While the effect of the split may only be temporary, a stock split is a great way for a company to make its stock more affordable to average investors, attract greater investor interest, and increase its price per share.

Understanding Reverse Splits

Stock splits are sometimes referred to as forward splits. However, a company could also choose to execute a reverse split, the opposite of a stock split. With a reverse split, investors have fewer shares of the stock than they previously held but at a higher price per share.

A company’s board of directors might choose to execute a reverse stock split if they are concerned that the price of the shares is getting too low and they’re in danger of being delisted from the exchange. In April 2020, for example, the United States Oil Fund ETF (USO) executed a stock split of one for eight. Before the split, its stock was trading at a price of around $2 or $3 per share. After the split, the stock was trading around $18 or $20 per share.

Understanding Reverse/Forward Stock Splits

This is a strategy that companies sometimes use to eliminate shareholders who hold a small number of shares. With this strategy, the company executes a reverse stock split to reduce the number of shares that stockholders have. This causes some shareholders to hold fewer than the minimum number of shares that are required by the split to be cashed out. The company could then perform a forward split to increase the number of shares again.

The bottom line is that stock splits can happen, and it’s important for investors to understand the impact it can have on their portfolios. While a forward or reverse split shouldn’t technically have an impact on the value of the shares, a forward stock split is considered a growth move by the company, reflecting positively on the value of its shares.