Hearing the recent announcements of stock splits from two large companies in the S&P 500, Apple and Tesla, has brought about thoughts of a possible resurgence that other companies may follow suit.
There was a time when stock splits were very common on Wall Street. In the late 1990s and early 2000s it was all the rage as companies attempted to make their share prices lower to entice the average investor. As an example in 1997 there were 102 companies in the S&P 500 that split their shares. In 2019 there were only a total of 5 and thus far in 2020 there have been 2.
So why the initial decline? Some studies have shown that stocks with higher share prices tend to attract fewer short term traders which in turn can reduce volatility, something that management likes. Also driven somewhat by the idea that high-price stocks are a mark of distinction.
Take for instance, Warren Buffett’s Berkshire Hathaway (BRK-A). It has never had a stock split. Each share is currently trading at $309,990 (as of 8/20/20) which is far too costly for most investors to buy 1 share let alone 100 shares. Why does Warren Buffett not split Berkshire Hathaway? It’s because he wants to attract serious investors whose interest is in long term plays and not a speculator trying to day trade.
What are stock splits?
There are two types of stock splits: forward and reverse. The most common is a forward split, where a company splits its stock into smaller pieces. Splits are denoted in ratios. For example, a two for one split is shown as 2:1. Both Apple and Tesla are Forward Splits.
Assume you own 100 shares of Apple (AAPL) stock at the current price of approximately $473 (8/20/20). The total value of your Apple holding is $47,300 (100 shares times $473). Since Apple just announced a 4:1 stock split effective August 28, 2020, you will receive 4 shares for each 1 share of Apple you own. As a result, you will now own 400 shares and the stock price will be divided by 4 to equal $118.25. Hence, your total Apple holdings remains the same at $47,300 (400 shares times $118.25).
As you can see, a stock split does not affect the total value of your investment, but rather simply gives you more shares with a lower price per share.
It is possible that after a stock splits the share price could increase. As many market participants, including small investors, think the stock is now more affordable and buy the stock, this can enhance the demand and drive up the price. Another reason for a price increase is that a stock split provides a signal to the market that the company’s share price has been increasing and people assume this growth will continue in the future, and again, push up demand and thus, prices. This concept is known as price discovery. When more participants buy and sell the shares of a company, the true and fair value of the share can be arrived at.
A reverse stock split is the opposite and not as common. It is when a company consolidates the number of existing shares of stock into fewer, proportionally more valuable, shares. The process involves a company reducing the total number of its outstanding shares in the open market but increasing the stock price proportionately. For example, a 1:3 reverse stock split would mean that an investor would receive 1 share for every 3 shares that they currently own. A reverse stock split does not increase the market capitalization of a company, although the number of shares outstanding decreases, the stock price is adjusted accordingly. The company’s market capitalization remains the same. The shareholder is unaffected by a reverse stock split regarding value.
A few reasons why a company would want to conduct a reverse split would be:
- In order to continue to be able to be traded on Exchanges. Exchanges have a minimum stock price requirement. On the New York Stock Exchange if a company stock price closes below $1 for 30 consecutive days the company could be delisted. By conducting a reverse split the shares outstanding would be less but the stock price would increase.
- Stocks that trade under $5 are considered “penny” stocks. With that comes the connotation of higher risk, something that companies may want to avoid.
To conclude, a forward stock split is used primarily by companies that have seen their share prices increase substantially. Though the number of outstanding shares increases and price per share decreases, the market capitalization does not change. As a result, stock splits help make shares more affordable to market participants and provide greater marketability as well liquidity thus leading to price discovery.
So which companies will be next to split – Amazon? Netflix? Google? Stay tuned.