What Are Stock Splits, and Why Do Stocks Split?

January 31, 2023 Advanced
Understand what a stock split is, why companies split shares, and how a stock split impacts your position.

When a company announces it's going to split its stock, what implications does this have for investors and their portfolios? Here are some key points about stock splits and the investing impacts behind the announcement.

What is a stock split?

Stock splits can take many forms, although the most common are a 2-for-1 split, 3-for-1 split, and 3-for-2 split.

A company’s management and its board must approve a split, then publicly announce its intention to do so. The actual split usually takes place within a few days or weeks.

So what does a stock split look like? Let's walk through some basic mechanics.

Take that pile of stock in front of you and double or triple the number of shares—heck, let's get a little crazy and multiply it by 10. That's what happens when a company splits its shares. Now you have more shares than you had before, but are you richer or otherwise better off? The short answer: Not on the surface.

Let's look at a common scenario, which is a 2-for-1 split: Investors receive one additional share for each share they already own. The stock price is halved—$50 becomes $25, for example—and the number of shares outstanding doubles. Splits can be at higher ratios from a 1-for-3 split to some recent splits that created 20 new shares for each original share. Fractional splits can occur too, such as a 3-for-2 split.

Stocks can also undergo a reverse split, where the number of outstanding shares is reduced and the corresponding share price is increased. In a 1-for-2 reverse split, two $5 stock shares become one $10 share.

In either case, not much else changes; the company's market capitalization—that's the total value of all outstanding shares—and other key financial metrics remain the same. Market professionals have long debated the merits of splits and whether investors realize any benefit.

Why do stocks split?

Why do companies split shares? Psychology, for one. As a stock price climbs, some investors, particularly smaller ones, may view the shares as too expensive and out of reach. A split, in theory, takes the price down to what may be a more attractive or accessible level, while also feeding a notion among existing shareholders that they have "more" than they did before.

Splits allow people to buy more shares. When investors believe they can buy more shares at a lower price, they seem to perceive that as a "deal" for the stock, even though the value hasn't really changed.

Traditionally, a lower stock price allows access to investors with smaller portfolios with less risk of overweighting the portfolio into one stock. This means investors can maintain their preferred levels of risk by maintaining their asset allocation and diversification mix. Today, “odd lots” of stock, that is, those not in blocks of 100 shares, don’t have the same stigma they once did, and finding an investor with 4 or 204 shares is much more common than in the past.

But not all companies play the split game. Warren Buffett, for example, has been quite vocal over the years about the folly of splits, stating quite plainly that his company, Berkshire Hathaway (BRK/A), will never split. Shares of BRK/A trade for about $463,000 apiece as of December 2022. Of course, BRK has issues the “B” shares, achieving a similar result by different means. Similarly, Alphabet (GOOGL) went for almost eight years with no split, with the share price ultimately rising to $2,750 before the company announced a 20-for-1 split in July 2022, which took the adjusted share price down to $112.64 immediately after the split.

Amazon (AMZN) split its share three times between June 1998 and August 1999, only to see its share price climb to $2,786 before also splitting 20-for-1 in June 2022, dropping the share price to $125 at the next opening.

With a reverse split, a company can potentially reduce the trading volatility of its shares by increasing the price or perhaps dampen speculative trading by making trades more expensive. Companies may also engineer a reverse split to keep the share price above a set value, such as $1, when falling below that price point would cause the stock to be delisted from its exchange.

Trading and investing around a stock split

For investors, seizing a split as the deciding factor in whether to buy a stock is commonly seen by investing professionals as inadvisable. For traders, one way to visualize the impact of stock splits might be to explain that if one dollar bill is split into four quarters, or ten dimes, that does not change the value of one dollar. Years ago, it was common for traders to buy shares after a split because they believed stock tended to rise toward the presplit price within a year. Rather than being related to splits, it seems growth of stock share price took place because of fundamental and technical factors attracting investor interest, essentially the market’s interest or lack of interest in the stock after the split drove the stock price, just as it did before the split.

Some investors believe that a stock split is a bullish sign that reflects the board’s expectation of a rising stock's positive momentum in the marketplace. Similarly, a reverse split is viewed by some investors as a sign that a company is signaling that they expect growth and profitability will be shrinking and the stock could continue to lose value. Of course, this could be speculating a great deal into the behavior of a board of directors, as their motivation could be the price of the stock now. Keep in mind firms often provide earnings guidance, a very direct comment from the firm. Also, analysts examine and write on the financial condition of various stocks and present their expectations in the form of buy sell and hold ratings. Certainly, when looking for information on a stock there are alternatives to reading the tea leaves of stock splits.

There's also an older trading strategy built around splits that once was ubiquitous but now seems of a distant era. Using this outdated approach, you'd buy a stock about two weeks before the announced date of a split, then sell it about two days ahead of the actual split. Stocks slated to split tended to rally into the split, then sell off after the split occurred. The effect was especially pronounced during the dot-com bubble. But, like many short-term trades or arbitrage opportunities, patterns changed. With this strategy, traders tended to create a self-fulfilling prophecy, but investors are savvier today than they were in the '90s and early 2000s. They now realize the value of the stock isn't changed through a split, so the excitement over splits just isn't there.

While the returns after a stock split may vary depending on market conditions, in the end, the value immediately after a split is the same. In other words, no matter how many slices you cut up a 16-inch pizza in to, it's still a 16-inch pizza.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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