What Is a Stock Split? (And Should You Invest in One?)

With several high-profile stock splits occurring in 2022 — including Google, Amazon, and Shopify — I’ve been reading a lot of misinformation lately about what stock splits are, how they work, and what opportunities they present for investors.

I’ve even seen TikToks claiming that we should expect Google to double this year thanks to the split on July 15.

I mean, it might — it’s friggin’ Google — but not because of the split. That’s just not how splits work.

So let’s clear things up and start from the beginning.

• What is a stock split?
• Why do companies do them?
• What typically happens to a company’s value after a split?
• Should you invest right before a stock split?

Let’s dive in!

What Is a Stock Split?

A stock split is when a company “splits” each of its existing shares into two, three, sometimes even 20 shares without affecting its market cap. The main purpose is to make each share more affordable to the average investor.

For example, let’s say the Bluth Company has 10 million shares outstanding and each share is trading for $1,000. That’s a market cap of $10 billion.

Furthermore, the Bluth Company is expected to continue a healthy growth pattern, driving share prices up even higher.

While high share prices are usually an indicator of good performance, they’re actually problematic for both the company and its investors.

• Retail traders may not be able to afford them.
• Fund managers are forced to buy shares in restrictive multiples of $1,000.
• Even investors who can afford them don’t like paying $3,000 for three measly shares.

In simple terms, high share prices are clunky and awkward and investors generally don’t like them.

Therefore, CEO George Bluth Sr. might suggest a 20-for-1 stock split. This would lower the price of each share to $50, making it easier to buy, easier to trade, etc.

So how does a stock split actually work?

How Does a Stock Split Work?

A stock split starts when a publicly traded company realizes that its share price is probably getting a little too expensive.

At that point, the company’s board of directors votes on:

1. Whether or not to do a split; and
2. What split ratio to use.

The most common split ratios are 2-for-1 and 3-for-1, although 10-for-1 and even 20-for-1 aren’t unheard of — especially for big blue chip companies with runaway stock prices.

For example, on June 6, 2022, Amazon did its first stock split in 23 years — a 20-for-1 that lowered the share price from roughly $2,447 to $122. Walmart (WMT) has done nine splits since 1975.

On that note, stock splits are fairly common. According to Fidelity, there have been between 20 and 30 stock splits per month since the beginning of 2022.

If they’re so common, are there other incentives involved for the companies filing the paperwork?

Why Do Companies Do Stock Splits?

1. To Make Share Prices More Affordable

As mentioned, the no. 1 reason why companies do stock splits is to make share prices more affordable. Cheaper shares means folks can buy more, trade more, and invest more.

The increased trading activity brought on by more affordable shares leads to benefit no. 2:

2. To Boost Float and Liquidity

Liquidity is how quickly and easily shares of a stock can be bought and sold without the overall share price being too affected.

Float is how many shares are available on the open market at a given time — the “available inventory,” so to speak.

High liquidity and high float are both key indicators of a healthy stock. The pair together are like motor oil in an engine. And when you do a stock split, your float doubles and liquidity greatly increases — effectively “lubricating” the stock.

3. As a Flex/Humblebrag

Finally, a stock split can generate hype and free press about your company and its solid performance. It’s a bit like a company flexing so hard it bursts out of its t-shirt.

Then, the company gets to go, in its best Arnold voice: “Oh, no, I’ve gotten too big and strong. Better get new clothes/do a stock split.”

Humblebrags and free press can help attract new investors, but again, the main motivator behind stock splits is to make share prices more affordable.

But wait a second. What’s the point if fractional shares are already a thing?

Stock Splits vs. Fractional Shares

Now that many brokerages offer the ability to buy fractional shares of stock, are stock splits really necessary? Why should I wait for Google’s stock split if I can just buy 0.08 of a share on Robinhood right now?

Well, according to Varun Marneni, an advisor with Atlanta’s CPC Advisors and Raymond James Financial Services, fractional shares have a few hidden shortcomings:

1. Liquidity

Not all brokerages want your fractional shares. If Robinhood has nine traders trying to sell 0.1 shares of Amazon, it may need to wait for one more to make a whole share that another brokerage will buy.

2. Employee Incentives

Companies like to award whole shares to employees as incentives, and stock splits make that easier.

3. Investor Psychology

Many experienced and institutional investors don’t want half a share of Amazon in their portfolio — they’d much rather have a nice, clean, 10 whole shares.

So while fractional shares are definitely convenient, they don’t erase the motivations and benefits of a true stock split.

What Happens to Your Shares During a Stock Split?

In short, you’ll wake up with more shares but the same amount of capital invested.

Let’s say you have 1.63 shares of GOOGL. On July 15, Google will issue you more shares so that your total share count multiplies by exactly 20. So that’s 32.6 shares.

The stock doesn’t literally split like an amoeba, though that would be cool.

Oh, and your individual shares lose 95% of their value. Instead of 1.63 shares worth $2,230 each, you’ll have 32.6 shares worth $111.50 each.

Finally, onto the big question: how do you make money during a stock split?

Should You Invest in a Company Right Before a Stock Split?

Let’s dive headfirst into this myth that stock splits drive performance. Is the TikTok “finfluencer” in the intro right? Can we really expect Google to double after its split this year?

Stock splits don’t automatically send share prices to the moon. In fact, most of the time, they barely impact performance at all.

Research by Schaeffer’s that analyzed 240 splits over 10 years found that over 50% of the time, stocks actually underperformed the S&P 500 in the six months following the split.

“Stock splits don’t seem to mean a whole lot for their performance going forward.”

Research by BofA Securities as reported in Reuters found that when stocks do outperform the markets following a split, it’s not because of the split. Rather, it’s the other way around — the company’s existing performance drove the split in the first place.

“Companies that announce splits have likely seen sustained market outperformance and expect that outperformance to continue.”

That may come as a surprise. I mean, if the whole point of a split is to make shares easier to trade, why doesn’t a split become a buying frenzy that shoots prices up?

Stock Splits Have Surprisingly Little Impact on Performance

A stock split is like cutting a cake into smaller pieces.

It won’t make the cake bigger.

It won’t make the cake taste any better.

It might attract one or two people who didn’t want a big slice. But ever since those people have been cutting their own slices, the line of people waiting for a small slice has all but disappeared.

That’s why stock splits have little direct impact on performance. Investors are either bullish or bearish on stock splits, and they tend to balance each other out.

The Bottom Line

That all being said, if you see someone cutting a cake into 20 tiny slices, that might be an indicator that it’s a darn good cake. It could be a sign that a lot of folks like that cake, and it’s growing in popularity.

Therefore, the actionable takeaway is this: stocks that are undergoing splits aren’t easy, automatic wins — but they are worth investigating.

If you are seeking an easy win and a high likelihood of returns in the long run, head here next: Why Index Funds Cost Less, Reduce Risk and Make You a Better Investor.

Featured image: YesPhotographers/Shutterstock.com

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Source: moneyunder30.com