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Why Do Stocks Split?

Why Do Stocks Split?

Publicly-traded companies place shares of their stock on the stock market. Each share of a company’s stock serves a purpose for both the company and the shareholder.

Owning a share of stock means owning a piece of the company as an investor. It also means building personal wealth as a company’s overall value increases. To a company’s board, it means growth or expansion as each share assists with raising capital.

Companies often announce a stock split, from big names like Apple or Alphabet, Inc. to smaller publicly-traded companies. What does this mean to the company and the investor? Why do they decide to conduct a stock split?

Read on to learn more.

What Is a Stock Split?

Let’s say you have a family of four and are ordering a large pizza from your favorite pizza parlor. Normally, the pizza is sliced so that 10 slices are up for grabs.

Now, let’s say that you’ve invited friends over, but you split the same pizza up into 20 slices instead of ordering another pie.

This is essentially what a stock split is (just omit the food).

It's not good or bad when a stock split is announced — it’s neutral. A company either increases the number of outstanding shares on the market by adding new shares (forward stock split) or decreases them (reversing stock split).

Regardless of the direction of the stock split, there is often a change in market capitalization to the company or the shareholder. The primary change is to the stock’s price per share on a stock exchange, either through additional shares added or shares taken off the market.

Interested in upcoming stock splits? Stay in the know and check out the stock splits calendar.

Is Stock Dilution a Concern?

Adding more shares has its perks, but it is also known to dilute the percentage of ownership stockholders have. If a company has a strategic plan in place, the shareholder may not feel the effects of the temporary change in share price.

Remember, by adding shares, a company is encouraging more owners. A company can invest in capital to enhance its operations with more owners.

A stock split is one way a company experiences dilution. Other methods include secondary offerings, mergers or acquisitions, and employee stock offerings. These moves do not always affect a company’s total value.

Engaging in Stock Splits: Why Do Companies Do This?

A stock split means a change in the market value of a single share of their stock. The market is sensitive to the economy and a company’s growth. Investors that bought in early at a low price per share love to watch a company’s stock price increase.

What about smaller investors?

Companies may take part in stock splits to make the price per share more appealing to new investors.

Just because the price peaks doesn’t mean a company will announce a stock split. Management reviews historical trading data before bringing it to the board of directors for approval.

Aside from the stock’s value, companies choose stock splits to:

  • Increase cash on the Balance Sheet
  • Increase capital for upcoming projects or expansion
  • Acquisitions or mergers
  • Reduce debt

Which companies participate varies based on whether they consider themselves to carry growth stocks or value stocks.

Growth Stocks

Growth stocks take flight faster than the economy is expecting, often due to a change in the value of the company selling shares.

Based on their growth patterns, they are labeled as high-risk investments. A company’s earnings are above-average; however, the value can fall quickly if the brakes are pumped even the slightest bit.

Company earnings are typically reinvested for the next latest and greatest concept. Therefore, growth stocks do not pay out dividends. Investors solely rely on their gain or loss from the stock’s change in value.

Although the upward movement is an excellent sign, it leaves the price per share high on the market. Companies know this and are less likely to engage in stock splits.

Examples of growth stocks include:

  • Tesla
  • Amazon
  • Meta
  • Netflix
  • Google

Value Stocks

Value stocks are more affordable on the market, representing slow-growth companies.

Value stocks entice investors by offering dividends (with a high dividend yield). Other features of value stocks include low price-to-book ratios (P/B Ratios) and low price-to-earnings ratios (P/E/ Ratios).

Examples of value stocks include:

  • Procter & Gamble
  • Johnson & Johnson
  • Berkshire Hathaway
  • Coca-Cola

What Is a Forward Stock Split?

When forward stock splits are declared, this is generally a good sign.

It means that the company is thriving. New stock shares are about to be introduced to the market, reducing the current price-per-share and increasing the number of shareholders.

The lower price may ruffle the feathers of current shareholders, but its intent is temporary. Within a short amount of time, the price should be back on the rise.

Here is an example of a forward stock split:

A company calls for a 2-for-1 stock split. This means the company is issuing one share for every investor's share, doubling it.

You’ve invested in this company, purchasing the share at $10. Upon receiving the second share now issued, there is no change in value to your portfolio. You still own $10 worth of shares, except that now you own two versus one (each valued at $5).

Barrick Gold is one of the world’s largest mining companies. There have been two stock splits on record for the company (2003 and 2004). Both were 2-for-1 splits.

What Is a Reverse Stock Split?

You know the saying, “one step forward, two steps back?”

A reverse stock split moves backward, the opposite of a forward stock split.

A company may choose to declare a reverse stock split to raise the price per share of its stock. Going backward may either be a positive or negative sign.

A reverse stock split may happen when:

  • A company feels that the trading price is too low, and investors are not attracted to it. Boosting the price may make it more attractive on the market.
  • Spin-offs are anticipated or being created (the parent company distributes shares of a subsidiary so that it stands alone or acts independently)
  • A company is at risk of staying compliant with the exchange's minimum bid price.
  • The stock is falling behind, or the company is showing signs of struggle, leaving the reverse split as an attempt to extend its life-cycle

Let’s look at the same example from a forward stock split, except in reverse:

The company decides to issue a reverse stock split, 1-for-2, to reduce the number of shares outstanding. The two shares you currently own are now reduced back to one with no change in value. You still own $10 worth of stock.

Some stockholders may receive a “cash-out” during a reverse stock split. This results in the investor no longer owning company shares. In addition, the prices may fluctuate just enough to where the original investment is in a position of loss.

What Are the Advantages of a Stock Split?

Advantages of a forward stock split include the following:

  • The price per share is reduced, allowing new investors an opportunity for ownership and rewards
  • A signal is sent to investors that it could be a good time to purchase stock as demand is about to increase and a company is profitable
  • Liquidity increases
  • A company’s capital costs decrease

NASDAQ performed a study showing an average boost of 2.5% to stock when stock splits are announced. After a year, there was an outperformance of nearly 5%!

A reverse stock split has advantages, too, such as:

  • Ability to stabilize a company that is showing signs of struggle. The increase in the stock price may appear more attractive to investors.
  • Keeping a company on the exchange, removing the risk of delisting
  • The company can compete against its main competitors in the market

Are There Disadvantages?

There are always pros and cons to every investment decision.

Here are some disadvantages of stock splits to consider:

  • A stock split doesn’t change the value of the stock. There is no impact on what an investor initially pays.
  • Companies pay for stock splits to occur. Depending on the type of split, the fee they pay may be questionable. Could they have used the funds for something else?
  • What type of investor will be attracted by the split? This is a question for the company to answer, as they may prefer to have a long-term, dedicated investor holding their shares or short-term ones such as day-to-day traders.
  • In a reverse stock split, investors may see the change as an indication of poor financial health

The Bottom Line

Though you may not know the total number of shares a company issues on the market, being notified that a stock split will occur is not a bad thing. It’s especially favorable if your number of shares owned is about to increase.

Stock splits are not meant to devalue the shares you own but to encourage more investors to jump on the bandwagon. A forward stock split is a good indicator that a company is financially stable and rising.

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Sources:

Stock Splits | FINRA.org

Reverse Stock Splits | Investor.gov

3 Compelling Reasons for Companies to Split Stocks | Nasdaq

Stock Splits Calendar | Nasdaq

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