Stock splits rarely happened when stocks were physically available and traded in paper form. The effort involved in withdrawing the shares and issuing new ones was high, and the process was expensive. With the implementation of electronic and centralized storage of stocks, the effort of stock splits has decreased significantly.
Nowadays, companies may decide to split their stock for various reasons. If you are looking to invest in the stock market, you should have an understanding of stock splits and also understand the reasons behind this procedure.
Types Of Stock Splits
Forward Stock Splits
A forward stock split is the classic version of a stock split. It is an increase in the number of shares in a company by splitting existing shares. This measure lowers the rated value of the individual stocks and thus also reduces their price. But at the same time, it increases the number of outstanding shares. This also means that existing shareholders will get additional shares for each share they already own.
Depending on the company, stock splits generally take the form of ratios like 2 for 1, 5 for 1, etc. There are much higher ratios possible, like in the case of Google. In July 2022, there was a split with a ratio of 20 for 1.
Reverse stock splits
A reverse stock split happens when the number of outstanding shares gets reduced, and with this, the stock price increases. In this case, the number of shares an investor is holding will be automatically decreased in his account by the number of the ratio.
Advantages Of Stock Splits
-
Affordable for private investors: Companies split their shares primarily to reduce the price of a costly stock, making it more accessible for investors. It is a normal means to motivate them to buy the shares. The only prominent person who always was against stock splits was Warren Buffet. To make it more concise: he is not against stock splits of other companies. But he doesn’t like the idea splitting stocks of his own company, Berkshire Hathaway. That’s why an original single share costs meanwhile around $430.000. If you want to buy nevertheless, you can do it with the B-stock, which costs around $320.
-
Increase of liquidity: However, not only the shareholders benefit from stock splits, but of course, the company as well. Because for a firm, a share split usually means more liquidity, since the visually more favorable share prices usually result in increased demand. As opposed to a capital increase, which can also bring in new money, the stock value of existing shareholders would not be diluted by a stock split.
-
Getting listed in an index: When the stock price is too high, it makes it for such a company impossible to get listed in some indexes. Dow Jones is such an example because it is a price-weighted index as opposed to Nasdaq or S&P500 which are weighted not by the price but by market capitalization.
Let’s take Amazon as an example. This firm is one of the most valuable in the world, and actually, such one should be listed in the Dow Jones because this index encompasses the largest corporations in the US.
In March 2022, Amazon announced a 20 for 1 stock split to be executed in June 2022. Before this happened, Amazon’s share price was on the last day of this event $2.785. And that’s why Amazon has never been listed in the Dow Jones.
The more expensive the stock, the higher weight it will get within the index. A stock like Amazon worth around $3000 per single share would cause a strong skew too far away from other companies. In other words, a single monster stock like Amazon (but also Google or Tesla) would determine a whole index! Thus, if a company wants to get listed in a certain index, it must do stock splits. As Amazon’s stock price is affordable after its stock split, would it be listed in the Dow Jones? Well, there is no information available about that yet.
-
Better conditions for options traders: one option on stocks is always related to 100 shares. When you sell a put on a stock with a strike of $400, and you would get the stock assigned, you would need $40.000 in your trading account to pay for these 100 shares. But after a stock split, for example, 8 for 1, the stock price would decrease to $50 per share. This makes it for options traders way more attractive to sell puts on that stock, and also in terms of portfolio diversification.
Disadvantages of stock splits
-
Worse performance of the stock because of the ETF influence: It is not a rule but just a possible disadvantage of stock splits for a company. Most of the managed money flows nowadays in ETF investments. That means many private and institutional investors don’t buy single stocks but stock baskets as ETFs. The distribution of the money in the EFTs occurs passively.
For example, if an ETF issuer has a $100 Million basket and wants to track an index, he has to purchase the respective stocks according to their weight within the index. When a stock has a weight of 15%, the issuer would spend 15% from its $100 Million basket.
But what happens when a company decides to do a stock split?
It usually decreases the weight of the stock within the index. In our example, we let the weight decrease from 15% to 5%. But what happens then? Well, when the weight of the stock decreases, the ETF issuer would buy fewer stocks of that company. In our example, it would be 5% after a stock split. In turn, the lower the demand, the worse the performance of the stock. But wait, the story continues. As the pay structure of the whole management board of a company is linked to the stock performance, it would affect the compensation and bonus payments of the management. And that’s a possible reason a company could decide not to split.
-
Higher annual fees for a company: Every company listed on an exchange has to pay a fee just because of getting listed there. And the fee is linked to the number of shares a company has. For example, if a company has more than 150 million outstanding shares, it has to pay from $167.000 up to $500.000 annually. Therefore, many companies don’t do stock splits because of the higher annual fee and other managing costs. Thus where a stock split may be advantageous for the investor, it usually doesn’t contribute to the performance of the company or changes its economics.
-
Attracting the wrong type of investors: Some companies, like Berkshire Hathaway, are interested in long-term relationships. That’s why they consider stock splits disadvantageous because of the lower price it could attract short-term investors like day traders. Keeping the price of a stock high can get it a kind of prestige and ensure an investor would keep it for a long time instead of “gambling” with the share.
Final Words
Stock splits have both sides of a coin, and it depends on the point of view. Private investors will get a chance to get stocks for a lower price. The company can pave its way with a stock split to get listed in an index. On the other hand, in some cases, a stock split can have some negative consequences, also for the management board and its compensation.
From an objective point of view, there is absolutely no reason for a company to do stock splits. Even the argument that a stock could become more attractive to private investors is not valid anymore. As some neobrokers like Robin Hood & Co offer fractional shares, a kind of “slice” of a whole stock. Therefore, stock splits nowadays are nothing more than cosmetic to push stock prices (even with the mentioned disadvantage of ETF influence). From the point of view of an options trader though, stock splits are usually a welcome opportunity for such types of trades.