In 2022 alone, three of the world's largest and richest tech companies, Alphabet Inc., Amazon, and Tesla, all announced stock split plans, and the mere mention of the planned splits caused their stock values to skyrocket. Alphabet's stock jumped 7.5 percent the day after the firm said it would divide its shares on February 1, 2022. So, what is it about a stock split that excites investors? And what message is a firm sending by dividing their shares 2-for-1, 3-for-1, or even 20-for-1? Derek Klock, a finance professor at Virginia Tech, spoke with us on the psychology of a stock split.
What Exactly Is a Stock Split?
Unlike a lot of financial jargon, this one is quite simple to grasp. A stock split occurs when a business decides to divide all of its outstanding shares by a specific number, such as two, three, five, or twenty. Only the number of shares in circulation and their individual prices change, not the total worth of the shares. Consider it like making a change. If you swap a $20 bill for two $10 bills, the total value remains the same, but you now have twice as many bills, each worth one-half of the original amount. Assume you exchanged that $20 cash for 20 singles, resulting in a 20-for-1 split. The overall value remains $20, but each bill is worth one-twentieth of its face value.
Stock splits operate in the same manner. Assume Company XYZ has 1,000 outstanding shares, each of which is worth $1,000. This signifies that the market capitalization of Company XYZ is $1,000,000. If Company XYZ issues a 2-for-1 stock split, there will be 2,000 outstanding shares with a $500 share price. "A stock split has no effect on the company's market valuation," Klock argues. "It merely alters the number of outstanding shares." The total worth of Company XYZ remains $1,000,000 (2,000 shares x $500), but there are now twice as many shares in circulation. So, if you own 10 shares of Company XYZ worth $10,000, following the 2-1 split, you'll have 20 shares worth $10,000. Because the stock price splits from $1,000 to $500, there is basically no change in economic worth. The decision to split a stock is taken by a company's board of directors and requires clearance from the United States Securities and Exchange Commission.
Why Do These Companies Do It?
Companies have historically issued stock splits when their stock price becomes excessively high. Isn't a high stock price a good thing because it indicates that the stock is in high demand? Both yes and no. A growing stock price indicates investor confidence in a company's future success; but, if a stock price rises too far, regular investors may be priced out. One of the justifications Amazon offered for its 20-for-1 stock split on March 9 was to "make the share price more accessible for consumers wishing to participate in the firm." To be honest, it seemed to work. Retail investors hurried to buy shares when Apple announced a 4-for-1 stock split in 2020. Retail investors are non-professional investors, such as yourself and me. When Apple reduced the price of each share by four times, ordinary investors increased their weekly purchases of Apple stock from $150 million to roughly $1 billion.
What Does This Mean For Regular Investors?
So, what are ordinary investors expected to make of this "signal"? Should you hold a stock that is poised to split if you own it? And, if you're considering investing in a company, does a split actually reveal anything about its financial health? As previously stated, a stock split does not provide investors with tangible information about a company's earnings or profitability; such information is provided in quarterly earnings reports. A stock split, on the other hand, is a reliable indicator that the people inside the company, who presumably know more about the company's future success than anybody else, believe things will only get better.
In terms of ROI, the "positive signal" of a stock split appears to be right. In 2019, Nasdaq conducted research on all major stock splits from 2012 to 2018. It discovered that simply declaring a stock split increased a stock's value by 2.5 percent on average, while split stocks outperformed the market by nearly 5 percent after one year. If you already own a stock that is due to split, the data suggests that the stock price will likely rise immediately. And if you're thinking about buying in a stock that recently split, there's a good chance it'll pay off. However, no investment is guaranteed, so consult a financial consultant before making any decisions.