Many investors might rightly wonder why companies announce splitting their stocks. After all, having more or less shares doesn’t change the overall picture for a company. From a mathematical perspective, a company that undertakes a stock split and those that don’t — like Berkshire Hathaway (NYSE:BRK-A, NYSE:BRK-B) via its A-class shares — should be valued on the same basis. And they are.
That said, the market views stock prices as important from a numerological perspective. Whether it’s to maintain a listing via a reverse split or increasing share count to broaden a company’s investor base, there are reasons for splits to take place.
Let’s dive into what stock splits are and why they matter. I’ll be focusing mostly on stock splits (increasing share count), but most of this commentary can be reversed for reverse stock splits.
Are Stock Splits Good for Stocks?
Companies typically undertake stock splits if they see their share prices are high and costly for investors to buy a standard amount (one full share, for example). Through the splits, the number of outstanding shares grows while the per-share price of a company’s stock declines. This improves liquidity and invites more options traders to the game.
More liquidity benefits both buyers and sellers, as the companies may allow buyback shares for more efficient and reduced costs.
While, theoretically, stock splits do not affect the value of a given company, they do often reignite investor interest that may help boost the underlying stock price. Investors in large companies, especially blue-chip ones, often see splits as bullish signals. That’s because these splits typically entail confidence about a given company’s future growth prospects.
Many top companies historically return to pre-split price levels, prompting subsequent splits. Walmart (NYSE:WMT), for instance, split its stock nine times on a 2-for-1 basis between 1975 and 1999, significantly multiplying shareholder holdings over three decades.
This strategy enhances marketability and liquidity, making it easier for smaller investors to participate, as seen with Amazon’s (NASDAQ:AMZN) 2022 split announcement coupled with a $10 billion share buyback.
Companies typically implement stock splits when their share prices become prohibitively high for new investors, signaling growth and future prospects positively. Post-split, stocks often experience price increases as lower nominal prices attract new investors.
Is It Better to Buy Stocks Before or After a Split?
Before deciding to buy a stock before or after a split, there are factors to consider. Such factors are current stock prices. Waiting until after a stock split may offer a more affordable entry point. However, the market has proven that buying before the split has added investor interest that can drive share prices in the long run.
For example, with 1,000 shares owned and valued at $10 each, and the company announces a stock 2-for-1 stock split, the investor would now own 2,000 shares with the same investment value of $10,000.
Each share would be valued at $5 post-split. However, dividends per share could decline after the split which will balance out the perceived advantage of share purchases before or after the split.
What Are the Disadvantages of a Stock Split?
While stock splits don’t affect the company’s fundamentals, they can still involve some losses and regulatory compliance. Despite dividing shares to lower the price, it doesn’t create additional value beyond enhancing market liquidity. This strategy is akin to slicing a cake — changing the number of pieces doesn’t alter the taste.
Implementing a stock split requires financial investment for regulatory compliance and legal support. However, it can attract a broader investor base, potentially diluting exclusivity for high-net-worth shareholders. Moreover, a stock split may reduce the face value of shares, posing risks if the company’s performance declines.
Conversely, a reverse stock split, although aimed at increasing share price, also entails legal and regulatory costs.
Furthermore, intentionally reducing a stock’s price can affect compliance with exchange rules like Nasdaq’s minimum trading price requirement, potentially leading to delisting if not rectified promptly.
Do Stocks Normally Go Up After a Stock Split?
Stock splits often attract investor attention, prompting companies like Tesla (NASDAQ:TSLA) to use them to generate buzz and attract more investors. Some companies regularly split stocks, which appeals to investors seeking to accumulate more shares. Although the split itself doesn’t change the stock’s value, investor enthusiasm often drives up prices after the announcement. In some cases, stocks may continue to rise even higher post-split.
Two main theories explain why companies opt for stock splits. Firstly, by reducing the share price, it becomes accessible to retail investors who may not have access to fractional shares. Secondly, high stock prices often restrict options trading, where contracts typically involve multiples of 100 shares. Lowering the share price through a split aims to increase investor participation and potentially drive up demand and the stock price.
The second theory suggests that a lower stock price enhances the chances of inclusion in price-weighted indexes like the Dow Jones Industrial Average. High-priced stocks are typically excluded from such indexes. Lowering the price increases the likelihood of index inclusion, prompting investors to anticipate these changes and buy the stock, potentially driving its price higher.
A stock split significantly improved trading conditions, reducing the bid-ask spread by 22%, increasing liquidity by 18% and lowering volatility by 3%, according to data compiled from the Nasdaq.
When Should a Company Do a Stock Split?
Most companies decide to do stock splits due to strategic considerations. When there has been a significant increase in stock value, companies consider splitting stocks to gain more investors. Research indicates that split stocks generally experience an average 7% increase in the first year and 12% growth over three years.
Some significant examples are companies like Apple (NASDAQ:AAPL). In 2014, the company traded at $600 per share, and the executives decided to have a stock split of 7-for-1. That reduced the share price to around $90 and improved Apple’s liquidity. Outstanding shares increased from 860 million to 6 billion.
At that time, the company had a $559 billion market cap, which increased to $562 billion after the split.
Another example is Berkshire Hathaway, but this was different than Apple. Although the stock traded at $350,000 per share in 2021, management did not opt for a split stock. Warren Buffett’s strategy was to deter short-term speculations and focus on the company’s long-term investment approach. Alternatively, the company offered class B shares, which traded around $230 each as of 2021.
Bottom Line
Stock splits do not alter a company’s intrinsic value. While they increase the number of shares outstanding, the total market value remains unchanged. Post-split, the share price adjusts proportionally to maintain the company’s market capitalization.
Dividends per share also adjust accordingly to maintain total dividend payouts. Additionally, stock splits are non-dilutive, ensuring shareholders retain their original voting rights.
Overall, splits matter, even though they shouldn’t. It’s just one of the ways the market works, for better or worse.
On the date of publication, Chris MacDonald did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
