What Is a Stock Split and How Does it Affect Investors' Profit?

Written by 
Polina Medianina
/
November 26, 2021

Answer: Samsung

Hover your cursor over the buildings and look at the connections between the companies
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Stock split Apple Tesla McDonalds photo

Many mistakenly believe that a stock split somehow changes an investor’s share in a company. So what is a stock split, and what goals do companies pursue when they do it?

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What is a Stock Split?

What does it mean when a stock splits? A stock split is an increase in the number of securities of an issuing company traded on the market at the expense of a decrease in their value for the same capitalization.

How does a Stock Split Work?

Every investor needs to understand how and when to do a stock split. A stock split, under country-specific laws and market rules, follows the next pattern:

  • A proposal for a split is recommended for consideration by the board of directors.
  • The shareholders approve the decision to split the securities at the general meeting by a majority vote.
  • The board of directors decides to issue additional investment instruments.
  • The necessary documentation is submitted to a country's main bank, and the issue is registered.
  • The active securities are converted into the issued securities within the stipulated period.
  • The report on the results of the issuance process shall be registered with the Central Bank Financial Markets Service.
  • The statutes of the issuing company are amended with regard to the number of investment documents and their nominal value.

No need to go far to understand why companies split their stock and find stock split examples due to the increase in the value of securities. In 2020, two of the largest and most famous companies, Apple Inc. and Tesla, did stock splits.

This is the fifth separation of financial instruments for Apple Corporation. The first four occurred in 1987, 2000, 2005, and 2014. This time the proportion was 4:1. What was the purpose of the stock split in this case? This allowed Apple to quadruple the number of shares on the stock market and reduce its price from $400 to $100.This way, the Cupertino company received a double effect of a stock split:

  • the price reduction made the paper more accessible and attracted the attention of the mass investor
  • the share price now does not stand out as much among other companies in the Dow Jones Index.

For Tesla, this was the first 5:1 split (recall that its stock had been up about 295% since the beginning of 2020).

Now you will be able to answer the question: “When a stock splits, what happens?”

However, you might be interested to know that there are also examples of companies that don't want to incur the large administrative costs of conducting a stock split and trading over $1,000 worth of stock. These are, for example, Amazon, whose securities averaged more than $3,000 apiece in September 2020, and Alphabet (which controls Google Inc.), about $1,500 per share over the same period. And while Amazon's management understands why a company splits its stock, they're not following Tesla's path anyway.

Why does a Company Split its Stock?

It's important to understand that there are different types of stock splits. The most common stock splits are 2-for-1, 3-for-2, and 3-for-1.

Each developing company is interested in the inflow of additional funds, which directly depends on attracting many investors. But not every trader or even an investment fund can afford to buy the costly shares of a growing company, no matter how promising it might be. Therefore, such a company divides the increased price of its shares by stock split ratios. What is the purpose of a stock split? The number of securities increases, and their proportionally reduced price becomes more attractive to the retail customer.

When splitting is carried out

The need to split financial instruments usually arises at two stages of a firm's development:

  • Having given up on bank lending, the firm issues financial instruments to aspiring co-owners at a very high price. But then, due to the need for additional capital investment, it has to issue securities for trading on the stock exchange. Consequently, a stock split must be applied for the initial sale of securities to the general public (IPO).
  • Provided the issuing company is constantly growing and developing, the value of its securities will also continuously increase, which will eventually also push the split to make the shares more attractive and accessible to a broader audience of investors.

Why does a stock split occur?

When and how does a stock split work? There is an opinion that stocks are just like any other commodity. Therefore, the stock price must be "convenient," that is, available to the mass investor. If you have $1000, it is psychologically more pleasant to buy 10 shares for $100 than 1 share for $1000. In the former case, you are the owner of a "batch of securities,” while in the latter case, you own just one share. And when you consider that stocks are often sold in batches of many shares at once, becoming an investor at a high single share price will be problematic.

Issuers often take the decision to split securities. Some firms do this more than once in the history of their public existence, realizing all benefits of a stock split. But there are also those who fundamentally refuse the splitting procedure.

The most striking example is Berkshire Hathaway Inc., Warren Buffett. Now one security is worth $340,262. Thus, the owner makes it clear that he is not interested in the influx of numerous private investors, who are often involved in speculating on the stock market. Berkshire Hathaway positions itself as a company for serious and long-term investors, and the company does not see reasons for a stock split. Each buyer is seen as a partner and owner of part of W. Buffett's business.

So far, the same policy has been followed by Amazon. True, the price of the paper is much lower than that of Berkshire Hathaway: it costs $3,172. But even this sum is not affordable to every private investor.

Consolidation of shares: What is it, and why is it needed?

In investing, there is a procedure that is the reverse of a stock split: stock consolidation. It increases their value and decreases their number. It is most often done when a company wants to meet the requirements of a particular stock exchange. For example, Nasdaq can delist an instrument if its value stays at $1 for a month.

The consolidation procedure is less reliable than the separation procedure. A decline in value that requires an increase in the asset price could indicate problems in the company. The investor wonders why the stock is not in demand in the stock market or why it is actively selling off. They draw their own conclusions and start selling securities too, causing an even bigger collapse.

How Stock Splits Affect Investor Returns?

We’ve contemplated what a stock split means. It's time to consider the benefits of stock splits for investors.

Stocks become more affordable

Usually, a stock split on the chart (optical price movement) causes the price to fall.

In a 1:2 stock split, where two new shares are issued for one old share, the face value and market value are suddenly halved, leading inexperienced investors to believe that the price has dropped by 50%.

What is the result of a stock split? The number of shares increases, their price drops, and they become more affordable for investors; however, the total value of the shares remains intact as a stock split doesn’t influence it.

Stock splits can contribute to positive price development

What happens when stocks split? Stock splits can contribute to positive stock price development, but not necessarily. Consequently, it should not be assumed that such a move will automatically positively affect price development.

The mere announcement of a stock split is not in itself a reason to buy. In most cases, one can assume that a stock split will attract new investors, but before buying, be sure to analyze the company’s overall position and include its prospects in your assessment. In this case, a stock split will only be an added benefit.

Psychological comfort

It is easier for shareholders to buy Tesla stock for $200 than for $1,000. But that's just psychology. As far as finances are concerned, not much changes for the investor.

Final Thoughts

We’ve reviewed why companies do stock splits and what benefits a stock split has for an investor. All in all, a stock split doesn’t influence the value of shares but makes stocks more affordable for investors (which is especially relevant for fast-growing companies whose stocks become more and more expensive).  

To join the most successful investors, you need to be among the first to receive the most important information. The Gainy app will help you do just that.

FAQ

What does stock split mean? What happens when a stock splits?

A stock split is an increase in the number of securities of an issuing company traded on the market at the expense of a decrease in their value at the same capitalization.Stock split leads to the division of existing shares into shares of lower par value. The share capital itself remains unchanged; only the number of the company's shares changes. A split is designed to facilitate the trading of securities. The opposite process, i.e., combining several shares with a larger par value, is called a reverse split.

What is the effect of a stock split? Does capitalization change?

To understand what a stock split is, you need to understand the law of transposition in arithmetic: the sum does not change when the summands change places. The sum, in this case, is the market capitalization of the company (that is, the total value of all the shares). In other words, no matter how the number of shares and the price change, the market capitalization at stock splitting remains unchanged.

Why does a company split its stock? What is a reverse stock split?

As a rule, the need for a stock split arises when market value shares are very high or significantly higher than the share prices of competitors in the industry. A reverse split is a process of combining securities when the number of shares decreases, but the value of each security increases.

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