With large companies announcing upcoming stock splits, it’s natural to question ‘What is a Stock Split?’ and ‘What does it mean for me?’. The following article is a beginner’s guide stock splitting and how to navigate through the key areas of doubt and uncertainty that many investors experience.
What is a Stock Split?
A stock split refers to when a company increases their total number of shares with the aim to increase the accessibility of the shares to investors and boost the stock’s liquidity. Through this process, the price of a share decreases, whilst the value of the company remains the same.
Using the analogy of a pizza, you can assume the pizza represents the collective value of the company. Now let’s believe that the pizza is cut in quarters and each quarter is worth $5. If the pizza undergoes a 2-for-1 ‘stock split’, that means the pizza is now cut into eight slices, so the new slice is worth $2.50. However, whilst there are more slices of pizza available, the total value of the pizza remains the same.
A stock split works the same way. Using a 5-for-1 stock split as an example, for each share currently owned, existing shareholders will receive 5 shares. During the process, the company divides each existing share into 5 new shares, implying that the new share value will be a fifth of the original share price.
Why do companies decide to do a stock split?
There are a few reasons why a company may decide to do a stock split. The first is the perceived liquidity of the company. Dependent on the ratio used by the company, the lower the share price, the less risky the stock appears to be. Therefore, investors perceive the company’s stock as more favourable and may be more enticed to purchase their shares.
The second reason is simply that the stock is now more affordable, and therefore can be used to peak the attention of new investors who may have been reluctant to purchase or potentially unable to afford the stock at its original price.
Does a stock split affect the value of a company?
In simple terms, no.
The increase in the number of shares is equivalent to the decrease in the price of shares, leaving the total value of company shares equal. Mathematically speaking, if you had a 3-for-1 stock split of a share originally valued at $9 and let’s assume there are 100 shares in the company, the total value of the company’s shares would be $900. After the stock split, there would now be 300 shares, valued at $3, which still brings the total value of the company to $900.
However, whilst the direct action of the stock split does not change the value of a company, the increased affordability of new stocks may generate greater consumer sentiment and demand, which may increase the value of the stock.
How does this affect you as an investor
Generally, stock splits don’t make a significant impact positively or negatively on the performance of a share, especially over the long term. At the time when the stock split is announced, or once the stock split occurs, there may be more trading-based activity, however after the news settles, usually, the activity tends to stabilise again.
As shares are more accessible to investors, existing investors may experience some volatility in the short term as shares are more easily traded in terms of price. However, like with all investments the trends tend to stabilise over the long term.
In 2022 alone, numerous global giants announced stock splits of varying ratios. In March, Amazon announced a 20-for-1 stock split after consecutive years of stable growth. Their shares traded for over $2,000 per share and post-split shares were trading at just over $100 a share. Similarly, Tesla announced a 3-for-1 stock split in August, following a recent 5-for-1 stock split they conducted in August 2020.
Should you take advantage of a stock split?
It’s tempting to want to purchase a stock after its price has decreased. Human psychology tells us that investors prefer to purchase 100 stocks priced at $10 than 10 stocks priced at $100. However, as an investor, you still need to do your due diligence to ensure that the stock aligns with your personal investing goals. Taking the BHP example into account, just because the stock has now become more accessible doesn’t necessarily mean it necessarily aligns with your portfolio and overall investment strategy.
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