What Is a Stock Split and How Does It Work?

What Is a Stock Split and How Does It Work? - What Is a Stock Split and How Does It Work?

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  • Stock splits are just simple arithmetic, altering the share count to influence the stock price.
  • Amazon (AMZN) recently split its stock; Alphabet (GOOG, GOOGL) and Shopify (SHOP) will do the same soon.
  • A company can go through a stock split or a reverse stock split.

In the summer of 2020, a number of big-name companies began announcing stock splits. (Yes, I’m talking about Apple (NASDAQ:AAPL) and Tesla (NASDAQ:TSLA)). Despite the current bear market, a number of other companies are also announcing stock splits, leading many newer investors to ask the simple question: What is a stock split? 

A stock split really is simple arithmetic. If company ABC has 1 million shares trading for $10, the company is worth $10 million. 

If company ABC wants to do a 2-for-1 stock split, it will double the number of shares from 1 million to 2 million, but then divide the stock price by a factor of two, so $10 becomes $5. How much is ABC worth now? 2 million shares multiplied by $5 gets us to a valuation of $10 million.

See? It’s just arithmetic. However, that inevitably leads us to a few other complexities. With that in mind, let’s take a closer look at what a stock split is and how it works.

What Is a Stock Split Good For?

Moving past our understanding of what a stock split is, you might now wonder what a stock split is good for. A stock split is good for drumming up demand. Not only do stock traders tend to front-run an event like this — meaning they buy the stock ahead of the event — but it seems to create sustainable demand beyond the split date. 

According to one study by Bank of America, S&P 500 companies that split their stocks tend to enjoy strong gains versus the rest of the index. Specifically: “Based on data since 1980, S&P 500 … stocks that have announced stock splits have significantly outperformed the index in the three, six and 12 months after the initial announcement. Stocks that have split gained on average 25% over the next 12 months compared with a gain of 9% for the benchmark index.”

You can also see it in Amazon (NASDAQ:AMZN), which split its stock earlier this month. Other notable stock split surges include Apple and Tesla — both of which occurred in August 2020. 

What Companies Are Splitting Their Stock?

As mentioned above, Amazon was the most recent notable company to split its stock. It underwent a 20-for-1 stock split on June 3, bringing its stock price back down to a more palatable level for investors. 

While a company doesn’t have to split its stock, it’s a lot more encouraging for investors to buy 10 shares rather than 0.50 shares. It also gives greater liquidity to a stock, given the big moves we can see on a four-figure stock. A lower stock price also gives the impression of a cheaper stock, even though the valuation has nothing to do with the share price. Meaning, a $1,000 stock can be a lot more expensive than a $1 stock, valuation-wise. 

For an idea of what it looks like for companies that don’t split their stocks, look no further than the A shares from Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B). The stock has recently fallen $147,000 a share from its peak.

As for other notable stock splits on the horizon, Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL) is set for a 20-for-1 stock split and Shopify (NYSE:SHOP) will soon undergo a 10-for-1 split. Tesla is expected to perform a 3-for-1 stock split, pending shareholder approval.

What Is a Reverse Stock Split?

Investors came here asking, “what is a stock split?” But there’s also  a reverse stock split to consider as well. It’s simply the opposite of what I discussed above. 

Instead of multiplying the share count and dividing the share price, reverse stock splits divide the share count and multiply the share price. A company might resort to this tactic in an effort to boost its share price. 

One reason for that may be to keep it out of penny-stock status. Another reason would be to drum up interest among institutional investors. Lastly, it may be a requirement of the exchange to maintain a certain minimum share price. 

For instance, if company XYZ has 10 million shares outstanding and the stock is trading for $1, the company — which is worth $10 million in this scenario — may elect for a 10-for-1 reverse stock split. 

In doing so, there will be just 1 million shares outstanding (dividing the share count by 10), but they will trade for $10 immediately following the split (multiplying the stock price). Notice how the company is worth $10 million in both scenarios. 

Recent companies to undergo a reverse stock split are General Electric (NYSE:GE) and Rite Aid (NYSE:RAD). 

On the date of publication, Bret Kenwell did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Bret Kenwell is the manager and author of Future Blue Chips and is on Twitter @BretKenwell.


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