Tesla split its stock 5-for-1 in August 2020. Amazon also did the same at 20-for-1 in June 2022 and Alphabet at the same ratio in July 2022. Nvidia split its stock 4-for-1 in March 2024. Broadcom announced a stock split at 10-for-1 in June 2024. These are some of the publicly traded companies that had their stocks split over the more recent years. What exactly is a stock split? What is the purpose of splitting a stock? What are its advantages and disadvantages?
Explaining Stock Split: Definition, Purpose, Advantages, and Disadvantages
Definition and General Purpose
A stock split or stock divide is an action taken by a company that involves issuing more shares to current shareholders in a predetermined ratio by dividing the original share into multiple shares. For example, in a 2-for-1 stock split, each shareholder receives two new shares for every share previously owned. The 5-for-1 stock split of Tesla resulted in its shareholders owning 5 shares after the split for each share they owned before the split.
The main purpose of a stock split is to increase the number of the outstanding shares of a company. It is worth noting that the total value or market capitalization of the stock remains the same despite an increase in the number of outstanding shares. The price of each share is reduced in proportion to the stock split ratio. For example, if a stock traded at $100 per share before a 2-for-1 split, its new price would trade at $50 per share after the split.
A stock split can be likened to cutting a pizza into more slices. The total size of the pizza based on its total size and weight remains the same before and after cutting it into more slices. What changed is that there are more smaller slices that could be distributed. Hence, based on this illustration, the more specific purpose of a stock split is to increase the liquidity of a stock by increasing the number of its outstanding shares and lowering its stock price per share.
Advantages and Disadvantages
The increase in the liquidity of a stock after a stock split benefits both corporations and investors. A stock split has more specific advantages. However, in several instances and due to more specific reasons, some corporations refuse to split their stocks. Berkshire Hathaway has a long-standing policy of refusing to split its Class A shares despite its astronomical stock price to attract focused long-term investors and discourage short-term traders.
Advantages of Stock Split for Corporations:
• Increased Liquidity: A stock split results in a lower stock price per share. This can attract more investors who have priced out of the high stock price of a company and can lead to a more active of its shares in the stock market. Remember that the common reason companies initiate a stock split after a large run-up of their stock prices.
• Psychological Appeal: It is also worth noting that initiating a stock split can be seen as a signal of confidence from management and indicates a healthy and growing company. This positive perception can boost investor sentiment and potentially lead to a short-term rise in share price and sustained high levels of trading volume.
Disadvantages of Stock Split for Corporations:
• Cost Implications: One main disadvantage of a stock split centers on the associated costs. These costs generally include legal and administrative fees. Those with limited cash flow could be burdened by these costs and would be forced to cut down expenses in other areas. A stock split is also not ideal for financially struggling companies.
• Increased Trading: Most companies benefit from having their stocks traded in the market at high volume. Some prefer keeping a moderate level of trading volume. Berkshire refuses to split its stock representing its class A shares to prioritize buy-and-hold investors. A stock split lowers a stock price and encourages short-term trading.
Advantages of Stock Split for Investors:
• Increased Accessibility: Remember that a stock split drives down the price per share of a particular stock and increases its trading volume. This benefits both smaller investors and existing shareholders. Smaller investors can now afford to invest in a stock after a split and the shares held by shareholders now have a lower liquidity risk.
• Growth Potential: A more affordable and liquid stock often translates to further growth potential via price appreciation. The decrease in price and increase in trading volume would attract more investors. A lower stock price also indicates more room for growth. The higher demand can eventually result in a higher stock price in the future.
Disadvantages of Stock Split for Investors:
• Unchanged Value: Take note that the total value of the stock of the company does not change after a split. The same is true for the shares held by investors. The value of their total investments does not change. An investor who holds shares of a company that has undergone a stock split simply owns more shares at a lower price.
• Short-Term Volatility: It is also possible that a stock split can result in short-term market volatility. The interest over a particular stock before a split can increase. The initiative can also attract short-term speculation from short-term trades looking to profit from the price volatility. A split can also overshadow fundamental indicators.