A number of well-known companies are splitting their shares recently, including Amazon (NASDAQ: AMZN), Alphabet (NASDAQ: GOOGL), Tesla (NASDAQ: TSLA), and GameStop (NYSE: GME).
Splitting shares is a common tool used by companies with high stock prices to increase (or decrease) the number of outstanding shares and decrease (or increase) their face value.
How the market views stock splits is described here.
Normally (or forwardly) splits and reverse splits are the two types of stock splits.
What is a stock split?
Forward stock splits result in a company’s outstanding shares increasing due to the stock split.
The share value of each share of the company will become smaller after a split. Consequently, each share will trade at a lower price following the split.
Due to lower stock prices, increasing the number of shares outstanding makes it easier for people to buy and sell stocks.
The value of a stock does not increase either through forward or reverse stock splits. The company’s market capitalization is also not affected by them.
When a company declares a forward stock split, existing shareholders will receive additional shares for every share they already own.
A stock split can be compared to slicing a pizza.
The pizza is first cut five ways, with five slices going to each person. The pizza is then cut ten ways, so every person gets two slices, but they all get the same amount.
As a result of this feature, it becomes easier to share pizza among a large group, however the quality and quantity of the pizza are not affected.
Examples of stock splits
The following companies have recently split their shares:
- Google-parent Alphabet announced earlier this year that it would split its stock 20-for-1 on July 15, 2022. It is the company’s first stock split since April 2014.
- An announcement was made by Amazon It this year that it would split its profits 20-for-1.
- There will be a 4-fold split in Nvidia (NVDA) 1 forward stock on July 20, 2021.
- On August 31, 2020, EV manufacturer Tesla (TSLA) conducted a 5-for-1 stock split.
- GameStop (GME) plans a 4-for-1 stock split on July 21 this year, following a meme-stock trading frenzy in 2021.
Reverse stock split
In a reverse stock split, the number of shares outstanding decreases and the share price increases.
When a company authorizes a 1-for-2 reverse stock split, it means that for every two shares held previously, there will now be just one.
As a result of our example, you would end up with 100 shares of $20 each. You still have a $2,000 investment.
It is possible for a company to reverse a stock split if it believes that it cannot attract investors with its current stock price. Reverse splits can also occur when a company wants to regain compliance with the stock exchange’s minimum bid price requirements according to the Securities and Exchange Commission.
While reverse stock splits can help a company maintain its listing on a major exchange, they are usually a sign of trouble for the company.
Among the Wall Street firms that have executed reverse stock splits are Citigroup, General Electric, Alcoa, and Xerox Holdings.
After the 2008-09 global financial crisis decimated Citi’s stock price, the company conducted a 1-for-10 reverse split in 2011.
The stock of General Electric was reverse split in 2021 by 1-for-8.
Why do companies split their stocks?
Several factors contribute to a company’s board’s approval of a stock split.
- Increasing stock prices: A company splits its shares primarily to reduce the price of expensive shares so that investors can buy and sell them more easily.
Increasing the price of shares of a particular company may drive away new investors. As a result, stock splits provide more investors with access to stocks.
- Increase in liquidity: There are more shares in forward stock split circulation. As a result, liquidity can increase significantly, making trading easier. It is easier for stock traders to buy and sell stocks at affordable prices when liquidity is increased. It is also possible to execute trades very quickly when there is high liquidity.
- Create more interest: Often, a company that declares a stock split is considered to be successful. Stock splits show that the company is a good investment because its stock price has risen so much.
Disadvantages of stock split
There are also some disadvantages to a stock split.
- Fundamentals remain the same: Shares have the same intrinsic value regardless of whether the company is in the process of splitting or reversing its shares. When a company is in bankruptcy or has weak fundamentals, a stock split won’t provide a long-term solution.
- The wrong crowd can be attracted: In spite of the fact that stock splits can make a stock accessible to more investors, there is no guarantee that a stock will attract investors who believe in its long-term success.
The additional liquidity arising from a stock split may attract many short-term traders who are not likely to stick with the company when it faces bad times. These traders look to capitalize on short-term price movements, which can be detrimental to the long-term success of the company splitting the stock.
Bottom line
There are many reasons why companies split their shares, but most of them have nothing to do with their fundamental performance. The value of a company or your holdings in it are unaffected by forward or reverse stock splits.
As a general rule, forward stock splits are viewed as positive because they make shares of companies more accessible to ordinary traders and investors. However, reverse splits can have a negative impact on the company’s value in the future.
An announcement of a reverse stock split may suggest that the stock value of a company is unlikely to improve anytime soon. It is possible that some individuals may put their money into a company that is more likely to succeed in the long run.
