What are Stock Splits?


Stock splits have been all the rage recently with two of the most talked about companies in the world partaking int hem them, Apple & Tesla. By announcing stock splits, these two companies have seen their stock prices rocket upwards and go Stratospheric. So what are stock splits and why are they sending share prices higher?


What Is A Stock Split?

A stock split is a procedure that increases a company’s total number of shares outstanding without altering the firm’s market value or the proportionate ownership interest of existing shareholders.

 

Imagine a large 16” pizza that is shared equally between two friends. It doesn’t matter if it is sliced into 4 pieces or 8 pieces. Although slicing by 8 pieces makes each slice smaller, both friends will still have the same amount of pizza.

 

Mathematically, nothing changes with a stock split. The number of outstanding shares increase in proportion to the split, but the share price decreases in an inverse proportion.

 

In other words, a 2-for-1 stock split doubles the share count but halves the stock price. The market cap stays the same. So if the company was “expensive” before the split, it’s still expensive afterward.

 

A stock split doesn’t make investors rich. In fact, the company’s market capitalisation, equal to shares outstanding multiplied by the price per share, isn’t affected by a stock split. If the number of shares increases, the share price will decrease by a proportional amount.

 

If a stock traded at £20 previously, it will trade at £10 after a 2-for-1 split. Yes, you own more shares, but they’re each worth less. It’s basically a draw, and the value of your investment won’t change.

 

Why do company’s take part in stock splits?

Although the value of the company stay the same when a company splits its stock in to more parts, company’s still do so as they argue they want to attract more investors by making the price more affordable and increasing the number of shares available.

 

Look at Amazon shares trading over $3,000. Not many people can afford to invest $3,000 in one go. If Amazon had to do a 10-for-1 stock split, each share would be worth $300 which would make it way more affordable and bring in many more investors.

 

This is the reasoning behind Apple’s announcement of a stock split. The company claims a stock split will “make the stock more accessible to a broader base of investors.”



Why Do Stock Splits Make Share Prices Go Higher ?

If the company’s value stays the same after a stock split, why do the shares go higher? This is a tricky one and more to do with investor sentiment as opposed to the underlying value of the company.

 

Investors generally react positively to stock splits, partly because these announcements signal that a company’s board wants to attract more investors to invest in the stock. Simple supply and demand. When demand for a stock increases, its price goes up.

 

I personally don’t believe in this. Many of the new online stock brokers such as Freetrade allow you to buy fractional shares. So in the example above, you don’t need the full $3,000 to buy shares in Amazon. You can buy 10% of an Amazon share for $300 or 5% of a share for $150. Fractional shares have already made ownership of stocks available to the masses.

 

There is another theory from Fred C. Kelly who wrote Why You Win or Lose: The Psychology of Speculation. The basic premise is stock splits are emotional triggers that entice new buyers. I will leave you with the following from Kelly:

 

“After a stock has had a wonderful advance, most people hesitate to buy it, because it looks too high. But keep it near its high mark, in a narrow range of fluctuations — with an occasional sale, higher than ever — and thousands of ordinary cautious people will begin to think all the good things they have heard about that stock must be true. It evidently isn’t too high after all.

 

This sentiment in times comes to permeate the whole financial community. Those who have been suspicious of the stock are held up to constant ridicule by the persistence with which it clings to higher levels.

 

Then stock split-ups aid to confirm the growing impression that the shares are not priced too high. Traders gladly buy a stock at $100 a share, soon after it has been split five-for-one — whereas they wouldn’t think of paying $500 a share. Even though our intelligence tells us that five shares at $100 are exactly the same as one share at $500, before the split-up, we nevertheless prefer to fool ourselves into feeling that the shares at $100 are better bargains.”