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Every industry has its jargon that makes things sound more complicated than it is. But, given the importance of investing, you should not let jargon stop you from creating long-term wealth.
It might be relatively easy to guess what a stock split means, but what are its implications? Does it represent good or bad news? What should investors do when this happens? Read on to learn about what happens with stock splits!
What Is a Stock Split?
A stock split occurs when a company decides to break up its existing shares to create more shares.
The net effect is the creation of more shares without a change in the valuation of the company.
>> More: How to Start Investing
How Do Stock Splits Work?
Every company has a certain number of shares outstanding available for investors to purchase when they go public on the stock exchange.
The company may decide later to do a stock split to produce more shares available to investors. As the name suggests, each stock gets divided to create smaller pieces of the company’s equity for investors to own.
A company would state how many shares it intends to split into and by which date it would take effect.
For example, a 5 for 1 stock split means that every existing share would be divided into five new shares, creating five times as many shares.
What Happens When a Stock Splits?
Creating more shares leads to a drop in price per share because the company’s value has split into more parts.
At the end of this action, you will continue to own the same value of the company but hold more shares than you had before the stock split.
Examples of Stock Splits
Nvidia and Tesla are the two high prolific companies that have recently undergone stock splits.
Tesla had undergone a 5 for 1 split towards the end of August 2020. Its shares rose 81% due to the split and ended the year with an additional 42% increase.
Nvidia performed a 4 for 1 stock split in July 2021. Its share price continued to rise by 20% to the time of writing.
What Is a 2 for 1 Stock Split?
To illustrate this, let’s talk about splitting our favorite $10 pecan pie.
A 2 for 1 split would be splitting our $10 pecan pie into two slices. Instead of having one whole pie, we now have two portions of pie. The price would be $10 divided by two parts, making each part worth $5.
Note that the price of the pie does not change whether or not you slice up the pie. So, likewise, the company’s value does not change, but only its price per share.
What Is a 4 for 1 Stock Split?
Back to our same analogy of splitting a $10 pie, a 4 for 1 split means to cut up the pie into four slices. So, we now own four portions of the pie worth $2.50 each ($10 divided by four slices).
Likewise, you would now own four times more shares for every share of the company you owned before the split. Again, the value of money you had invested in those shares does not change.
How Do Stock Splits Affect Investors?
The consequence of splitting the stock is dropping its price. In some brokers, investors are not allowed to buy fractional shares.
With the company lowering its share price significantly, more investors can now own the stock. This creates buying pressure that pushes the stock price further upwards.
Investors who already own shares of the company before the split usually stand to gain more from price appreciation through this phenomenon.
However, it is essential to note that there is no way to predict the price movements of stocks in the short term.
Is a Stock Split Good or Bad?
A stock split does not do anything for a company in the long term, but it may create short-term buying pressure, leading share prices to increase.
The valuation of the company is tied to the underlying business of the company. In most cases, the price per share of a company goes higher because investors are confident in the company’s future and its business.
Building on the positive sentiment towards their business, a company may decide to perform a stock split to entice more people to buy its shares, raising money to drive the business forward.
Whether the company’s business is truly impressive or simply riding the hype on their stock depends on fundamental analysis.
Therefore, it is essential for you as an investor to investigate why they are performing the stock split, or rather, what they intend to do with the money raised from investors.
Do You Lose Money on a Stock Split?
There is no money lost during stocks splits, for reasons discussed above. Because the reasons behind a stock split are usually positive, the share prices typically increase in the short term.
However, there is no telling that investors may react negatively to the news, creating selling pressure and hence causing the stock price to fall following this news.
What Is the Difference Between a Reverse Stock Split and Stock Split?
A reverse stock split is simply the opposite of a stock split.
Instead of increasing the number of outstanding shares with a stock split, a reverse stock split decreases outstanding shares. Likewise, the valuation of the company is not affected during this action.
In most cases, a reverse stock split is a bearish sign for the company’s stock price, at least in the short term. First, however, it is important to investigate the reason behind a reverse stock split, just as with a stock split.
You can read more about reverse stock splits.
Bottom Line: What Is a Stock Split?
A stock split is an action taken by a company to increase its outstanding shares, which lowers its price per share.
This can be enticing for investors who do not have access to fractional shares, leading to an increased buying pressure and hence, increasing stock price in the short term.
A stock split is usually associated with a positive outlook on the underlying business. However, investors should be cautious by revisiting their fundamental analysis before performing any transaction according to this piece of news.