What exactly is a stock split? How does it affect my investment portfolio?

You may have heard the term stocks split over the last few years as there have been multiple companies who have either gone through, or is planning on going through a stock split. You may have an understanding of what a stock split is or this may be your first time hearing the term. Either way, it is an important thing to know about so I will be going over everything you need to know in today's post

What is a Stock Split?

The term “stock split” refers to the act of dividing a company’s shares into smaller units. This action usually occurs when a company wants to increase its share price or reduce the number of outstanding shares.

Stock splits are often done to raise capital or to reduce the number of outstanding securities. They also occur when a company has a large amount of debt and wants to pay down some of that debt. 

There are many different types of stock splits that a company can choose to undergo if they so wish. These differences are in the form of the ratio of the split. For example, Tesla had a stock split in August 2020 which was a 5 for 1 stock split. This 5 for 1 split means that every share that exists will become 5 shares with each share having 1/5 the value of the original. Many other ratios are used such as a 20-for-1 stock split down to a 2-for-1 split.

What does a Stock Split do for a Business?

When a company goes through a stock split, the number of shares available for purchase increases. The theory behind this is that more people can buy the same amount of stock at one time instead of having to wait until they sell their entire position before buying another .

Fundamentally this stock split should do nothing for a company. This is due to the number of shares being more or less arbitrary number however, this does in fact have a big impact on share price but of course, not due to company fundamentals.

The main influence on share price comes from investor psychology. Investors seeing that a companies stock now look cheaper and that they can own more quantity of shares drives a lot of investors to the stock purely for that reason. There also instances, especially for larger value stocks, where the split has been necessary to lower the price for investors who can't afford a full share of the company and don't have access to fractional shares.

Although access to fractional shares has become widely available over the past few years, this doesn't stop investors flocking to stocks undergoing stock splits. I personally think that the expectation of investors putting liquidity towards a stock about to undergo a split also drives more investors to the stock in itself.

This overall can provide more liquidity to a business which could potentially help the business in many different areas.

How does a Stock Split Affect Investors?

A stock split affects investors because it reduces the value of each share. It doesn't matter how many shares you own, the total value of all your shares stays the same. However, if you owned 100 shares prior to the split, then you would only be able to hold 50 after the split.

The effect of a stock split on an individual investor is very minimal. If you were to invest $100 into a single stock that went through a 5 for 1 split, you would end up owning 5 stocks valued at $20 each. As mentioned in the previous section, stock splits can usually drive some hype and potentially other factors depending on the companies situation.

This can give current investors confidence in the business and may provide some short term profits if desired. However, just because a stock is or has undergone a split does not mean it will continue to go up. You don't want to be caught out at the top of a run and then the price comes straight back down.

What are Reverse Stock Splits?

A reverse stock split is the exact opposite of a regular stock split. This means that where you may have had a 4-for-1 stock split turn every 1 share into 4, you would now see a 1-for-4 stock split (4-for-1 reverse stock split) with every 4 shares becoming 1.

Reverse stock splits are used when a company wants to reduce the number of outstanding shares without reducing the actual number of shares. It's important to note that even though the number of shares are reduced, the total value remains the same just like a regular stock split. This also means that the market capitalization (market cap) remains the same.

Summary

Stock splits are often done by businesses as a way to increase their market capitalization. They are done so that investors can buy more shares of the company. The majority of times these splits are done to make the stock easier to trade and to encourage investors to purchase more shares. Even though there are benefits to splitting a stock, it's always best to do your research before purchasing any stock.

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FAQ

What Happens If I Own Shares that Undergo a Stock Split?

When a stock splits, it credits shareholders of record with additional shares, which are reduced in price in a comparable manner. For instance, in a typical 2:1 stock split, if you owned 100 shares that were trading at $50 just before the split, you would then own 200 shares at $25 each. Your broker would handle this automatically, so there is nothing you need to do.

Source: (investopedia.com)

Why Companies Do Stock Splits

A stock split is often a sign that a company is thriving and that its stock price has increased. While that’s a good thing, it also means the stock has become less affordable for investors. As a result, companies may do a stock split to make the stock more affordable and enticing to individual investors.

Source: (time.com)