A closer look at stock splits

Tesla (NASDAQ: TSLA), the world’s most valuable automaker, executed its first-ever stock split on August 31st 2020. Apple, the world’s most valuable company also carried out a stock split on the same day. Is this just some sort of trend or is there more to it? Let’s find out.

What is a stock split?

A stock split is a decision by a company’s board of directors to divide each of its existing shares into multiple shares. That is, splitting a whole unit of stock into 2, 3 or more parts.

Think of it like a $100 bill. Your one whole $100 bill is broken down into 5 pieces of $20 each or 10 pieces of $10 each. You still have the same amount of $100, just in smaller pieces.

So, in a stock split, if an investor holds one share of a company worth $200, a 2 to 1 stock split would divide the investor’s holdings into two shares each worth $100.

A stock split does not change the value of an investor’s holdings or the market value of the company. The main difference is that the amount of shares held by the investor is multiplied and the price per share is reduced.

Is this a new thing?

No, not new at all. Although this is the first time that Tesla will split its stock, stock splits have been happening since as far back as 1962. Here are some examples:

• The Walt Disney Company – six stock splits between 1967 – 1998
• Apple Inc -four stock splits (a fifth one is set to take place later this month) between 1987-2014
• Microsoft – nine stock splits between 1987 – 2003
• Google – two stock splits between 2014 and 2015
• Netflix – two stock splits between 2004 – 2015

Why do companies split their stocks?

One major reason companies split their stocks is to increase the overall liquidity, that is the number of shares available for trading. Increasing the liquidity of a stock makes trading in the stock easier for buyers and sellers because everything is cheaper.

Secondly, when a company believes that its share prices are too high they can decide to split their stock. For example, Tesla’s stock was trading at about $2,150 at the time of writing and many people might not want to invest at that high price. After the five-for-one stock split, the stock price will drop to around $430, which is a lot more affordable for investors.

Also, a stock split can be a way for some investors to make a little bit of money. When a split happens, other investors who had been on the sidelines can jump in and raise the price of the now split stock.

A reverse stock split

Interestingly, there is also a reverse stock split. It is used by companies to drive up share prices for investors when they get afraid of being delisted from the stock exchange. In a reverse split, instead of dividing the existing shares, the company collapses them. In a 5 for 1 reverse split, 5 existing shares will now form one while in a normal split, 1 existing share will become 5.

What does a stock split do?

In and of itself? Not much.

Like we mentioned earlier, stock splits do not affect the market capitalization or change the fundamentals of the company in any way. Stock splits also don’t automatically make an investor richer since the value of the holdings remains the same.

But, investors often react positively to stock splits. They can decide to reward the company by purchasing more stock and driving up the price as they did with Apple and Tesla. Studies also show that stocks that have split have gone on to outpace the broader market in the year following the split and subsequent few years. 

In the final analysis, the power of stock splits has waned over the years due to the rise of fractional investing. Accessibility to stocks is not as big a problem as it used to be since you can just buy any amount of the stock fractionally.

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