Understanding Stock Splits

Say you had a $100 bill and someone offered you two $50 bills for it. Would you accept the offer and make the trade? This might sound like a pointless question because most people don't get excited over a proposition like this. After all, you still end up with the same amount of money.

There are cases that present similar situations for people in the investment industry—stock splits. But unlike the $100 scenario, the mere mention of a stock split can get an investor's blood rushing. But how exactly do they work and, more importantly, are they worth all the excitement? In this article, we explore stock splits, why they're done, and what it means to the investor.

What Is a Stock Split?

A stock split is a corporate action by a company's board of directors that increases the number of outstanding shares. This is done by dividing each share into multiple ones—diminishing its stock price. A stock split, though, does nothing to the company's market capitalization. This figure remains the same, the same way a $100 bill's value doesn't change when it's exchanged for two $50s. So with a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share is reduced by half. This means two shares now equal the original value of one share before the split.

Let's say stock A trades at $40 and has 10 million shares issued. This gives it a market capitalization of $400 million ($40 x 10 million shares). The company then implements a 2-for-1 stock split. For each share shareholders currently own, they receive another share. They now have two shares for each one previously held, but the stock price is cut by 50%—from $40 to $20. Notice that the market cap stays the same, doubling the number of shares outstanding to 20 million while simultaneously reducing the stock price by 50% to $20 for a capitalization of $400 million. So the true value of the company hasn't changed at all.

Common Stock Splits

Stock splits can take many different forms. The most common stock splits are 2-for-1, 3-for-2 and 3-for-1. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. Using the example above, divide $40 by two and we get the new trading price of $20. If a stock does a 3-for-2 split, we'd do the same thing: 40/(3/2) = 40/1.5 = $26.67.

Companies can also implement a reverse stock split. A 1-for-10 split means that for every 10 shares you own, you get one share. Below, we illustrate exactly what effect a split has on the number of shares, share price, and the market cap of the company doing the split.

Reasons for Stock Splits

There are several reasons companies consider carrying out a stock split. The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy, while small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more attractive level. While the actual value of the stock doesn't change one bit, the lower stock price may affect the way the stock is perceived, enticing new investors. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before, and of course, if the price rises, they have more stock to trade.

Another reason, and arguably a more logical one, is to increase a stock's liquidity. This increases with the stock's number of outstanding shares. Stocks that trade above hundreds of dollars per share can result in large bid/ask spreads. A perfect example is Warren Buffett's Berkshire Hathaway (BRK.A), which has never had a stock split. Its bid/ask spread can often be over $100. As of March 2020, the class A shares traded over $257,000 each. 

None of these reasons or potential effects agree with financial theory. A finance professor will likely tell you that splits are totally irrelevant—yet companies still do it. Splits are a good demonstration of how corporate actions and investor behavior do not always fall in line with financial theory. This very fact has opened up a wide and relatively new area of financial study called behavioral finance.

Advantages for Investors 

There are plenty of arguments over whether stock splits help or hurt investors. One side says a stock split is a good buying indicator, signaling the company's share price is increasing and doing well. While this may be true, a stock split simply has no effect on the fundamental value of the stock and poses no real advantage to investors. Despite this fact, investment newsletters normally take note of the often positive sentiment surrounding a stock split. There are entire publications devoted to tracking stocks that split and attempting to profit from the bullish nature of the splits. Critics would say this strategy is by no means a time-tested one and is questionably successful at best.

Factoring in Commissions

Historically, buying before the split was a good strategy due to commissions weighted by the number of shares you bought. It was advantageous only because it saved you money on commissions. This isn't such an advantage today since most brokers offer a flat fee for commissions. This means they charge the same amount whether you trade 10 or 1,000 shares.

The Bottom Line

A stock split should not be the primary reason for buying a company's stock. While there are some psychological reasons why companies split their stock, it doesn't change any of the business fundamentals. Remember, the split has no effect on the company's worth as measured by its market cap. In the end, whether you have two $50 bills or single $100, you have the same amount in the bank.