Stock Splits: Are They Good or Bad?

Stock splits with has increased recently Amazon (NASDAQ: AMZN ), Alphabet (NASDAQ: GOOGL ), Tesla (NASDAQ: TSLA ), And GameStop (NYSE: GME ) They will split their shares in some well-known companies.

A split is a tool often used by companies with high stock prices to increase (or decrease) the number of existing shares and decrease (or increase) the face value of each share.

Here’s what you need to know about stock splits and how they’re viewed by the market.

There are two types of stock splits: normal (or forward) splits and reverse splits.

What is a stock split?

A forward stock split occurs when a company decides to split its stock, effectively increasing the number of shares outstanding.

After a split, one share will represent a smaller portion of the overall company than before. Therefore, each share will trade at a lower price after the split is completed.

Increasing the number of shares outstanding makes it easier for people to buy and sell stocks due to lower prices.

However, both forward and reverse stock splits do not increase the value of the stock. Further, they do not affect the total market capitalization of the company.

For existing shareholders of a company that has declared a forward stock split, this means they will receive additional shares for every share they already own.

The best analogy is to compare a stock split to slicing a pizza.

First, the pizza is cut five ways, with five people each getting a slice. It is then cut ten ways, meaning all five people have two slices, but they have the same amount of pizza.

It becomes easier to share the pizza among a large group of people, but the quality and quantity of the pizza has not changed at all.

Depending on the company, stock splits usually take the form of:

  • 2 for 1 or
  • 3 for 1 or
  • 5 for 1

Suppose you own 200 shares in Company Y and each share is worth $10, for a total of $2,000. If the company announces 1 forward stock split; This means you will now receive 2 shares for every 1 you own, or 400 shares, each share now worth $5.

Even though you now own twice as many shares, the total value of your haul remains the same at $2,000.

Examples of stock splits

Here are some companies that have done forward stock splits in recent history:

  • Google-Parent Alphabet Earlier this year it announced a 20-for-1 stock split with an effective date of July 15, 2022. This is the company’s first stock split since April 2014.
  • The online retail giant Amazon It announced a 20-for-1 split in March this year.
  • Nvidia (NVDA) 1 forward stock split 4-fold on July 20, 2021.
  • EV manufacturer Tesla (TSLA) Conducted a 5-for-1 stock split on August 31, 2020.
  • GameStop (GME), The company, at the center of a meme-stock trading frenzy in 2021, is scheduled for a 4-for-1 stock split on July 21 this year.

Reverse stock split

A reverse stock split occurs when the number of shares outstanding decreases and the share price increases.

For example, if a company authorizes a 1-for-2 reverse stock split, that means every 2 shares previously held will become just 1 share.

From our example, you would end up with 100 shares of $20 each. Again, your investment is still worth $2,000.

A reverse stock split can occur when a company believes that the stock price is too low to attract investors. The US According to the Securities and Exchange Commission, a reverse split may also occur when a company seeks to regain compliance with the stock exchange’s minimum bid price requirements.

While a reverse stock split can be good for a company because it helps them stay listed on a major exchange, it is usually a sign of a company in trouble.

Notable Wall Street firms that have executed reverse stock splits include Citigroup (C), General Electric (GE), Alcoa (AA), And Xerox Holdings (XRX).

Citi underwent a 1-for-10 reverse stock split in 2011 after its stock was decimated by the 2008-09 global financial crisis.

General Electric completed a 1-for-8 reverse split in 2021 to support its stock.

Why do companies split their stocks?

There are several reasons for a company’s board to approve a stock split.

As mentioned earlier, stock splits do not increase the value of the shares. Much of that comes down to making the stock more affordable for small investors and traders, and its behavioral benefits.

Following are the three main benefits that a company can experience after splitting its shares:

  • Make stocks more affordable: The main reason why companies split their shares is to reduce the price of expensive shares so that investors can buy and sell shares more easily.

If the shares of a particular company rise too high, the price may drive away new investors who cannot buy the shares. Hence, stock splits help make them more affordable for more investors.

  • Increase in liquidity: Number of shares in forward stock split circulation is higher. This can significantly increase liquidity, thus making it easier to trade the stock. Increased liquidity is better for stock traders as it is easier for them to buy and sell stocks at affordable prices. High liquidity also means that trades can be executed very quickly.
  • Create more interest: A company that declares a stock split is often considered a successful business. The fact that its stock price has risen so much that a stock split has to be done, suggests that the company must be a good investment.

Disadvantages of stock split

A stock split also comes with some disadvantages.

  1. It does not change the fundamentals: The intrinsic value of the shares remains the same whether the company is going through a stock split or a reverse stock split. Therefore, a stock split will not provide a long-term solution if a company is on the verge of bankruptcy or has weak fundamentals.
  2. They can attract the wrong crowd: Although stock splits often make a stock accessible to more investors, there is no guarantee that a stock will attract the attention of 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

Companies may decide to split their shares for a number of reasons, but they usually have little to do with the fundamental performance of the business. Forward and reverse stock splits have zero effect on the value of a company or your holdings in that company.

But generally speaking, forward stock splits are seen as positive moves because they make companies’ shares more accessible to everyday investors and traders. Reverse splits, on the other hand, can raise concerns about the future value of the company.

If a company announces a reverse stock split, it may mean that there is nothing on the immediate horizon that can improve its stock value. In this case, some individuals may choose to put their money in a company that has a more promising future.

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