What does a stock split mean? A stock split happens when a company increases its shares in order to boost liquidity of a stock. The dollar value of all shares stays the same, however. Many companies commonly issue 2-for-1 and 3-for-1 stock splits.
In this article, we’ll answer “What is a stock split?” — likely your most burning question, then dive into more details about stock splits.
What is a Stock Split?
There are two types of stock splits: forward and reverse splits.
- Forward stock split: The most common split, the forward stock split, is an action taken by a publicly traded company to divide one common share into a set number of smaller shares without diluting its market capitalization or a shareholder’s ownership stakes.
- Reverse stock split: Also called a reverse split, a reverse stock split dilutes the share price but not the total valuation. A company’s board of directors decide to issue more shares of its stock to current shareholders and grow its outstanding share count while maintaining its original market capitalization. The value of the split shares combined equal the original value of the single share. Therefore, a 2-for-1 stock split would mean a single share worth $60 would be split into two shares worth $30 each.
Whatever the split ratio, the value is also split by the same ratio. A 3-for-1 (which can be denoted as 3:1) stock split for a $60 stock would result in three shares valued at $20 each.
The number of shares would increase, but the value of the shares would remain the same. If a company has one million outstanding shares worth $10 each, then a 2-for-1 stock split would result in 2,000,000 outstanding shares worth $5 each.
If you owned 100 shares at $10 a share, your investment would be worth $10,000. After the 2-for-1 stock split, you would own 2,000 shares at $5 a share and your investment would still be worth $10,000.
What does a 4-for-1 stock split mean for a stock trading at $100? It means there will be four times more shares outstanding trading at $25 each post-split, or after the split takes effect.
How a Stock Split Works
What does it mean when a stock splits? The term “stock split” can be misleading because it implies that a company cuts a share of stock into pieces determined by the announced ratio, like taking scissors to a stock certificate and cutting it in half for a 2-for-1 stock split. That’s not what happens. It’s the opposite effect — shares are actually duplicated, not divided.
Stock splits create new shares at a cheaper valuation. The share price purposely gets diluted, but market capitalization stays the same as do the ownership stakes for shareholders. Stock splits are granted to existing shareholders, who receive new additional shares at a discounted ratio to the original share.
You receive more shares, but the value of each share drops in proportion to the ratio. For example, if you own 100 shares of a $10 stock, then a 2-for-1 stock split would grant you an extra share of stock worth $5
added to your existing share of stock now worth $5, leaving you with 200 shares of stock at $5 each. Keep in mind that the cost basis per share will also change when it comes to taxes. The end result leaves you with more shares but worth the same total value. Let’s take a look at three stock split steps.
Step 1: A company announces a stock split.
Companies will announce a stock split via a press release. In the press release, they specify three important pieces of information. They announce the ratio of the split, the shareholders of record date and the effective date or distribution date if announced as a dividend. Keep in mind that stock splits are commonly distributed as dividends, but unlike cash dividends, they are usually nontaxable. The ratio determines the number of pieces into which they will split a share of stock.
The shareholder of record date is the date you must own the stock to be eligible to receive the additional shares or dividend. The effective date or distribution date as a dividend is the date when the additional shares are placed in your brokerage account after the market close or the following morning.
Step 2: You receive your shares.
If you own shares on or before the stockholder of record date, then you should receive your additional shares after the close on the effective or distribution date.
Depending on your broker, you may see the additional shares the next morning before the market opens. For a 3-for-1 stock split, you would receive two additional shares for each single share you own after the close on the effective date. The value of the three shares would equal the value of the original single share prior to the last trade price before the split.
For example, your 100 share position valued at $300 would convert into a 300-share position still valued at $300, but at $1 per share on 300 shares.
Step 3: The market reacts.
In bull markets, investors tend to buy into stock splits as they may feel they are getting more bang for their buck by owning more shares afterward. This is why the stock price tends to elevate into the effective date. The morning after the effective date also tends to result in a price gap as new buyers come into the cheaper stock off the fence.
A stock that was too expensive to buy before the split becomes very appealing after the split when prices become cheaper. This was the case with some of the popular FAANG stocks like Amazon.com Inc. (NASDAQ: AMZN) and Alphabet Inc. (NASDAQ: GOOG) which were both trading over $2,000 per share ahead of their 20-to-1 stock splits in 2022. While shares initially ran higher on the announcement of the splits, they actually sold off lower after the stock split since the general market was turning bearish from interest rate hikes and a monetary tightening policy.
Advantages and Disadvantages of Stock Splits
While stock splits seem like a free lunch, they can be a double-edged sword depending on
macro market conditions and when you get in them. The results can be starkly different between owning a stock through a stock split and purchasing the stock after it splits. It pays to know how a stock split affects investors.
Advantages of Stock Splits
First, the advantages:
- Successful underlying performance: Stock splits tend to be associated with successful underlying performance as a company’s stock price rises out of reach.
- More affordable: The cheaper share prices post-split make it more affordable for investors to buy into stocks that may have been out of reach before.
- Bring new investors in: Stock splits bring new investors into the stock, making it more accessible while diversifying its shareholder base.
- Drive up share prices: Stock splits tend to drive up share prices on the announcement date and after the effective date as new shareholders buy up the cheaper shares.
- More liquidity: The increase in outstanding shares and new shareholders also enables more liquidity, often resulting in tighter bid and ask spreads, resulting in less volatility and slippage.
- Magnified profits: You’ll see gains as a shareholder of record. For example, owning 100 shares of a $40 stock that rises $1 produces a $100 net gain, but after a 4-for-1 split, owning 400 shares of a $10 stock that rises $1 produces a $400 net gain.
Disadvantages of Stock Splits
Now, the disadvantages:
- Shares may sell off more quickly: Shares may sell off more quickly after the split as a “sell the news” reaction takes effect. This results from too many investors chasing the stock higher, expecting a post-split rally that doesn’t happen.
- Minimized price movements: The additional liquidity may result in minimized price movements as the thicker float makes for frustratingly slow gains.
- Losses can mount: If owning shares through a stock split, the losses can mount at a greater and faster rate in a falling or bear market. For example, owning 100 shares of a $40 stock that falls $1 produces a $100 net loss, but after a 4-for-1 split, owning 400 shares of a $10 stock rises $1 produces a $400 net loss.
Example of a Stock Split
Electric vehicle maker Tesla Inc. (NASDAQ: TSLA) announced a 3-for-1 stock split on August 5, 2022. The company approved a 3-for-1 stock split that each stockholder of record on August 17, 2022, would receive a dividend of two additional shares for each single share owned after the close of trading on August 24.
Incidentally, Tesla shares were already rising on the rumor of a stock split, causing shares to peak at $940.92 on August 4, 2022. Tesla shares collapsed 6.63% when the stock split was announced the following day as the news reaction kicked in. Shares proceeded to slide lower after the effective date, opening at $302.96 post-split and selling off to $266.15 for the next six days. Shares further managed to collapse to a low of $177.12 by November 9, 2022. The TSLA stock split occurred in a technology bear market as the Nasdaq was down over 30% at the time. Unfortunately, shareholders that held through the stock split experienced a 41% net loss at the lows.
Stock Splits vs. Reverse Stock Splits
The second and less common type of stock split, a reverse stock split, is the opposite of the forward split because it attempts to reduce the outstanding shares as it elevates the value of each share. A reverse split converts each outstanding share into a partial share of stock relative to the announced ratio.
Therefore, a 1-for-10 reverse stock split on 100 shares of a $1 stock results in 10 shares of a $10 stock afterward. A forward stock split implies strong performance for the company but a reverse stock split implies the opposite. Companies that may be at risk of delisting will execute a reverse stock split to get the share price back up.
What Happens if My Shares Undergo a Stock Split?
If one of your stocks announces a stock split and you want to continue to hold it long term, then there’s nothing to do on your end. Your broker should automatically place the new shares into your account after the effective date of the split. It really is just business as usual.
Don’t be shocked when the price of the stock drops the next day from the forward split, as it will have to do. If your stock closes at $100 on the effective day for a 2-for-1 stock split, then don’t be surprised when the shares trade at $50 per share the next morning. Many shell-shocked investors have seen their stock price chopped in half without realizing that a stock split took effect.
Does a Stock Split Make a Company More or Less Valuable?
A stock split should be a net neutral event that has no impact on market capitalization. Even if a company splits its shares, the value of the company based on its market capitalization still remains the same. This doesn’t rule out the possibility for a price gap up or down the next morning as a result of new buyers or sellers and/or a stock futures gap. The reaction to the split will make an impact on its valuations just like any other trading day.
It Pays to Plan Ahead
While stock splits may not be as common as stock buybacks, they can make a material difference to investors. Remember that stock splits can be paid out as a dividend. These dividends are not taxable or qualify to be in the dogs of the Dow process.
Now that you’re familiar with the mechanics of a stock split, it’s important to administer discipline and avoid chasing prices. A stock split is a perfect opportunity to get in at a cheaper price. If you are a long-term investor, then time if your friend as stock splits can work to compound your gains over time, especially when investing in blue-chip companies.
