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Investing is a critical component of building wealth and could mean buying shares in some of your favorite companies. Businesses such as Amazon, Google, and Tesla are popular investments that have rewarded loyal investors over the years. However, their share prices can be high.
For example, prior to 2020, Tesla (TSLA) stock shares were selling for more than $2,000. When it performed a 5-to-1 stock split that same year, its shares became available for one-fifth of the previous price, which allowed investors to invest in the company for as little as $500.
But what is a stock split and how does it work? Let’s take a closer look and how it could affect your investment strategy.
What is a stock split?
A stock split occurs when a publicly traded company’s board of directors decides to split its outstanding shares into smaller ones. The result is new shares of a company available for a lower price point. The total value of the company, however, remains unchanged.
Some of the most valuable companies have share prices that easily creep into the four-figure range. If your brokerage doesn’t allow the purchase of fractional shares, buying shares of stock in these companies can be difficult. A lower share price matters because it lowers the barrier to entry for prospective investors.
A stock split can also increase the valuation of a company. The idea is that its share price has risen so much that it must be broken up so the average investor can afford it. Although that may be true, there are other benefits of a stock split than just a lower share price.
How does a stock split work?
A stock split involves dividing up existing shares into smaller ones. The company’s market capitalization (or market cap), defined as the number of outstanding shares multiplied by the share price, remains unchanged. You simply have more shares than you had previously, but at a lower price per share.
For instance, imagine a company that has 10,000 shares priced at $1,000 each. If it performs a 2-for-1 stock split, it will then have 20,000 shares priced at $500 each. The lower price for each additional share makes them more affordable for investors who may have avoided investing in the company earlier.
Besides making the shares more affordable, it improves the stock’s liquidity because it makes it easier for existing shareholders to sell or engage in stock trading. As a result, it may also increase the company’s value as more people buy the stock post-split.
Types of stock splits
The different types of stock splits are based on the ratio of the split. The most common types of split ratios are 3-for-1, 2-for-1, and 3-for-2. However, in all cases, a stock split will result in more shares priced lower. Regardless of the type of stock split, the company’s market cap is unchanged immediately after the split.
One example of a 2-for-1 stock split is Alphabet (GOOGL), the parent company of Google. In 2014, the company split its stock 2-for-1, which reduced Alphabet’s share price from $1,140 to $570. Most recently, Alphabet announced a 20-for-1 stock split. If that split were effective today, shareholders would have shares at a price of around $130 compared with the current price of over $2,500 per share.
Another popular example of a stock split comes from Tesla. The company split its share 5-for-1 in 2020. Because of the split, Tesla was able to reduce its share price from $2,213 per share to $442 per share, making it potentially possible for more people to invest in Tesla. Since then, Tesla shares have continued to appreciate, nearly doubling since the split.
What are the advantages of a stock split?
Lower barrier for new investors
If you are just learning how to invest in stocks online, a stock split can make it easier for you. The most obvious reason is a lower share price; it’s easier for investors to buy shares that cost $100 each compared to shares that cost $500 each. That’s a nice plus for publicly traded companies.
But there’s another reason a stock split can make it easier to attract new investors. When a company splits its stock, it is often seen as a bullish sign, a clear indication that things are going well. Investor confidence often increases, which leads to more people investing in the stock. Whether that confidence is warranted is another matter, but from the company’s point of view, it’s a benefit.
Increased liquidity
Stock splits increase the number of outstanding shares, which increases liquidity, or the ability to convert an asset into cash. If a stock goes from 10,000 shares outstanding to 40,000 shares outstanding, it creates a larger trading volume of shares without reducing the company’s valuation.
Lower bid-ask spread
Increased liquidity can also lower the bid-ask spread. In simple terms, the bid-ask spread is the difference between the bid price and the ask price. When stocks are traded more often, that gap narrows, and both buyers and sellers can get closer to their preferred price.
May increase share price
Stock splits could increase a company’s share price. In fact, even just the announcement of a split can cause a spike. Take Alphabet, which announced an upcoming 20-for-1 stock split of all of its shares. The very next day, its share price jumped 7.4%. That’s a remarkable jump in one day, especially for a stock that trades for well over $2,500 per share.
What are the disadvantages of a stock split?
Can increase volatility
Stock splits can increase volatility, at least in the short term. The new, lower share price can often attract investors, which pushes the share price upward. With Alphabet, even the announcement of a stock split can push shares upward. However, the initial 7.4% increase in price for shares vanished in the two following weeks.
May attract traders and inexperienced investors
People buying shares in a single company such as Tesla or Apple (AAPL) may do so hastily if there is a split. They buy the stock because of the suddenly lower price, not because they understand the company’s past performance and view it as a strong investment.
In reality, digging through a company’s books is an arduous task, but it’s generally a good idea when investing money in a single company. Hence, investing simply because the share price has dropped may not be the best decision.
Doesn’t always increase market value
A stock split on its own does not increase a company’s market cap; it only decreases the share price. A company’s value may increase if demand increases after the stock split. Each investor’s stake also increases in value in this scenario.
But this scenario is not guaranteed. If there isn’t pent-up demand for lower-priced shares, then a split may not increase a company’s value much, if at all.
What is a reverse stock split?
In a reverse stock split, a company consolidates its existing shares into fewer, higher-priced shares. Because this is a reverse of a stock split, it is expressed as a 1-for-2 ratio, for instance.
A company can carry out a reverse stock split for several reasons. Its share price may be falling and it may be in danger of being delisted from a stock exchange. The company may also want to increase its share price to attract new investors.
One example of a stock split is the internet security company Cyren Ltd., which performed a 1-for-20 reverse stock split on Feb. 9, 2022. Before the split, its shares were trading for about 20 cents. Immediately after the split, its shares traded for about $4.
For many investors, a 20-cent share price may be too low to treat a company as a legitimate business. On the other hand, $4 seems like a nice affordable stock. Hence the decision to carry out a reverse stock split.
FAQs about stock splits
How do stock splits work?
A stock split is when a publicly traded company splits its existing stock into additional lower-priced shares. With a stock split, the total value of all outstanding shares doesn’t change. For example, if a company has 10,000 outstanding shares priced at $200 each, a 2-for-1 stock split would result in 20,000 shares priced at $100 each.
Do you lose money on a stock split?
Investors often ask, can you lose more than you invest in stocks? Investors do not typically lose money as a result of a stock split. In fact, a stock split might increase the value of your investment as the lower share price draws in new investors. But there are some scenarios where you could end up losing money.
A reverse stock split is one possibility. With a reverse split, the number of shares is reduced. In some cases, stockholders could be “cashed out,” which leaves investors with less than a full share. Reverse stock splits can sometimes combine more than 50 shares into a single share. These splits can cause volatility in the share price, which may cause some investors to lose money.
What is a 4-1 stock split?
A 4-for-1 stock split is one in which a company splits each of its outstanding shares into four shares priced at one-quarter of their pre-split price. For instance, if a company’s stock is priced at $1,000, a 4-for-1 stock split will result in four times as many shares priced at $250 each. Typically, companies do this to make shares more affordable for investors.
Is a stock split good or bad?
A stock split is not necessarily good or bad. Stock splits come with a set of advantages and disadvantages, and companies have to weigh them before considering a split.
One advantage is the possibility of attracting new investors who otherwise may have been “locked out” of purchasing shares. And with lower share prices comes increased liquidity and a narrower bid-ask spread. This may even increase the stock price as trading activity picks up.
However, stock splits can increase volatility as the price of the stock spikes. It may also attract the wrong type of investor looking to capitalize on the lower share price rather than invest in the company.
Bottom line
If you are a long-term investor, a stock split isn’t likely to change your strategy because it generally won’t change the value of your investment. However, taking advantage of a stock split could allow you to buy shares in companies you previously couldn’t afford. Some of the best investment apps can help you purchase split stocks today.
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FinanceBuzz is not an investment advisor. This content is for informational purposes only, you should not construe any such information as legal, tax, investment, financial, or other advice.
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