To successfully trade in the market, it is important to understand the fundamentals of stock splits and what they can mean to you as an investor. In simple terms, a stock split is like being offered two $50 bills for a $100, but there are other dynamics at play.
A stock split occurs when a company increases the number of outstanding shares by dividing each outstanding share. This lowers the price of each, but the market capitalization remains the same. Like your $100 bill scenario, you still have the same value of stocks, you just have more shares.
For example, a company may have 10 million shares trading at $40 each. They make a decision to do a 2-for-1 split. This doubles the number of shares that each investor owns, except that each share is now worth only $20. So instead of having 10 shares worth $400, you now have 20 shares worth $400. Generally, stocks will split 2-for-1, 3-for-2, or 3-for-1. In some cases, a company may do a reverse stock split, where they condense shares. Thus, in a 1-for-10 split, every ten shares you have becomes one. If each stock was worth $10 before the reverse split, one new share will be worth $100.
Why companies split their stock
This may leave you wondering as to the point of it all, since the underlying value does not change. There are several reasons why stocks split.
One reason is purely psychological. If a price of a stock is skyrocketing, new investors may shy away from purchasing. Splitting the stock will attract new investors that can afford to invest at the new lower price. Conversely, it may also encourage those who already have stock to sell as prices go up again, since they feel that they have more shares to employ.
A more logical reason has to do with a stock’s liquidity. As the prices per share soar higher, the bid/ask spreads become larger as well. For instance, Warren Buffet’s Berkshire Hathaway has never split. The stock currently trades at over $100,000, meaning that bid/ask spreads can easily be over $1000. This prevents smaller investors from investing. Splitting a stock will allow for lower bid/ask spreads, increasing the liquidity of the stock.
Neither reason agrees with financial theory. If you talk to some financial experts, they will say that splits are irrelevant. However, they still happen, and stock splits are a great example of how the market does not always line up to financial theory.
Stock splits and your portfolio
You may wonder whether or not stock splits can be an advantage to your portfolio. Some analysts argue that stock splits are a good indicator to buy, since it means that a company is doing well and share prices are increasing. However, others argue that stock splits do not affect the underlying value of the stock, and therefore has no real advantage. However, there are often positive feelings around a split and a bullish market is created for the stock, though it does not make sense to invest purely on this theory alone.
You may have to consider commissions as part of your strategy. In the past, commissions were weighted by the number of shares you bought, making it cheaper to invest in the stock before the split. Now, many brokers use a flat fee per trade system, and thus, commissions are no longer as much of a concern.
All in all, stock splits do not affect the worth of the company, and they should not be the deciding factor as to whether or not you choose to invest in a stock. In the end, you still end up with the same value, just as a $100 is worth the same as two $50 bills. However, the investor perception surrounding the stock split may be enough to warrant an increase in the price.