Stock Split

Published Sep 8, 2024

Definition of Stock Split

A stock split is a corporate action wherein a company divides its existing shares into multiple shares to boost the liquidity of the shares. Although the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, because a split does not fundamentally change the company’s actual market capitalization. For example, in a 2-for-1 stock split, every shareholder receives an additional share for each share they own, effectively doubling the number of shares while halving the price per share.

Example

Imagine a company named TechCorp with 1 million shares outstanding, trading at $100 per share. This gives the company a market capitalization of $100 million. TechCorp announces a 2-for-1 stock split. Consequently, the company will now have 2 million shares outstanding. The price per share will adjust to $50, ensuring the market capitalization remains at $100 million. If an investor owned 100 shares at $100 before the split, they would now own 200 shares at $50 each after the split.

Why Stock Splits Matter

Stock splits are significant for several reasons:

• Enhanced Liquidity: Stock splits often result in enhanced liquidity as more shares become available at lower prices, making it easier for a wider range of investors to purchase shares.
• Market Perception: Stock splits can convey positive signals about a company’s future because they often occur when the company’s stock price has significantly increased, indicating robust performance and growth prospects.
• Psychological Impact: Investors may perceive stocks with lower prices as more accessible, encouraging increased buying activities even though the underlying value has not changed.
• Index Adjustments: Stock splits can affect a company’s weighting in certain stock indices. For example, in price-weighted indices like the Dow Jones Industrial Average, the weight of individual companies depends on their stock prices. Reducing the stock price through a split can reduce the company’s influence in that index.

Frequently Asked Questions (FAQ)

How does a stock split affect dividends and earnings per share (EPS)?

A stock split does not affect dividends or earnings per share in the underlying financial performance sense but does change the per-share calculations. If TechCorp paid a $2 dividend per share before a 2-for-1 stock split, post-split, it might pay $1 per share, keeping the overall dividend income for shareholders equivalent. Similarly, earnings per share are adjusted post-split to reflect the increased number of shares, ensuring that the price-to-earnings (P/E) ratio remains consistent.

Are there any downsides to stock splits?

While stock splits have several advantages, they can also have downsides:

1. Perception Risk: Some investors might misinterpret the stock split as a sign that the stock has become too high and may be overvalued.
2. Increased Volatility: Lower per-share prices can attract more speculative trading, potentially increasing short-term volatility.
3. Administrative Costs: Although minor, there are costs associated with carrying out a stock split, including legal and administrative expenses.

What is a reverse stock split?

A reverse stock split is the opposite of a standard stock split. Instead of increasing the number of outstanding shares and reducing the price, a company decreases the number of shares and increases the price per share. This might occur to meet stock exchange listing requirements or to attract investors by presenting a more favorable stock price. For example, in a 1-for-5 reverse split, a company would exchange five shares for one new share, thus if the pre-split price were $10, the post-split price would be $50.

Have any notable companies performed stock splits recently?

Yes, many high-profile companies have executed stock splits recently. For instance, in 2020, Apple Inc. performed a 4-for-1 stock split, while Tesla, Inc. executed a 5-for-1 split. These splits were undertaken after significant stock price appreciation, aiming to make their shares more accessible to a broader range of investors and enhancing liquidity within the market.

Does a stock split impact an investor’s ownership percentage in a company?

No, a stock split does not affect an investor’s ownership percentage. Each shareholder retains the same proportionate ownership in the company post-split as they held pre-split. The number of shares they own increases by the split ratio, but the overall equity stake in the company remains unchanged because the total number of shares issued by the company also increases proportionately. This ensures that the split does not dilute the equity position of any investor.