Stock split

July 27, 2023
10 MIN READ
61 VIEWS
A stock split occurs when a corporation raises the number of outstanding shares to improve the stock's liquidity. Even though the number of outstanding shares rises, the organization's total market capitalization remains the same since the cost of each share also splits. The most common split ratios are 2-for-1 and 3-for-1, meaning that every single share before the split will become numerous shares following the split. A stock split is performed by a firm to purposely decrease the cost of a single stock, rendering the store in the business cheaper without losing value. Reverse stock splits are the inverse operation in which a corporation reduces, rather than increases, the number of outstanding shares, raising the share price proportionally.

What is a stock split?

Stock splits are a method in which a corporation raises the number of shares to lower prices, making them more readily available to individual investors. Stock splits are decided by publicly listed firms in collaboration with their boards of directors. Forward and reverse splits are the two primary kinds of stock splits. When corporations divide stocks, it shows positive advancement and development, which leads to lower share prices and the development of a shareholder base as stocks become more readily available.

The concept of stock splits

Stock splits are an agreement made by a firm after consulting with its board of directors. Corporations that make their stock available to the public retain a certain number of units. They increase the number of outstanding shares, lowering the per-share price for dealers. Though the corporations split the stock for a reason, they ensure that current owners receive extra units equivalent to the amount invested.

Corporations usually announce a split when their share values have risen significantly. The practice, also known as share splits, lowers the value of the shares to make it more affordable for regular investors. In turn, it expands the businesses' investment base. Additionally, investors' faith in the firm has a beneficial influence on share prices, and a rise in the number of shares contributes to greater liquidity. This increase in liquidity improves market efficiency by decreasing the bid-ask spread.

Shares become more available to interested retail investors, but splits do not affect current owners other than an increase in the number of shares. On the other hand, as the number of stocks grows, future earnings per share (EPS) may decrease. Furthermore, share splits are tax-free. There are no tax ramifications because no money flows during share splits.

Market participants know the firm's great success as stocks split due to increasing stock prices. Consequently, shareholders expect that the business's achievements will continue to improve and remain profitable in the next years. Consequently, it increases both the demand for stocks and their prices.

Different kinds of stock splits

Stock splits take several forms. As a result, they are classed based on those trends, which are divided into two major categories: forward/traditional/conventional stock splits and reverse stock splits.

   i. Conventional splits

These are the most typical and conventional forms of share splits. In this case, a corporation raises the number of shares, lowering the cost to a multiple equal to the unit stock price. 2-for-1, 3-for-1, and 3-for-2 are the most prevalent forward split trends. In a 2-for-1 stock split, for instance, stockholders receive two shares after the split for every share they had before the split. Conversely, after the split, investors in the remaining two patterns receive three shares for every share and two for each stake, respectively.

   ii. Reverse splits

It is the inverse of a forward share split. In this situation, firms lower the number of shares issued to raise the unit stock prices. They use this to acquire their market position. When the stock prices of such firms fall below certain thresholds, the stock market that lists their stocks eliminates them. As a result, to maintain their market position, some companies choose reverse splits.

Why do corporations carry out stock splits?

When the share price of an organization rises to a nominal level that could make certain shareholders uncomfortable or when it exceeds the cost of shares of similar firms in the same industry, the board of directors may opt to split the shares. Although the firm's fundamental value has not changed, a stock split might make the securities more logical. It also improves the stock's liquidity.

When a stock divides, it can result in a gain in share price, even if there is a drop shortly following the stock split. It is because small investors may see the stock as more inexpensive and purchase it. It essentially increases stock demand and raises pricing. Another explanation for the rise in costs might be because a stock split signals to the market that the business's stock price has been growing; people may think this trend will continue. It increases demand and costs even more.

Apple Inc. divided its shares 7-for-1 in June 2014 to make them readily available to more investors. Before the split, the opening cost of every stock was roughly $649.88. At the market opening after the split, the cost per share was $92.70 (648.90 / 7).

The current shareholders received six more shares for every share before the stock split. As a result, a stakeholder who held 1,000 shares of AAPL before the stock split now owns 7,000 shares following the stock split. Apple's share count went up from 861 million to 6 billion. Nonetheless, the organization's market value remained constant at $556 billion. The cost had risen to a peak of $95.05 the day following the stock split, indicating higher demand from the reduced stock price.

The impact of stock splits on short sellers

Stock splits have no significant impact on short sellers. Certain adjustments arise due to a split that might influence the short position. They do not affect the worth of the short position. The number of stocks shorted, and the cost per share are the two most important changes in the portfolio. When shareholders short an asset, they obtain the stock intending to return it later. When a corporation divides its shares, the price of the shares divides as well.

The benefits of a stock split

When a business decides to divide its stock, the cost of a regular board lot of 100 shares becomes prohibitively costly for investors.

In addition, a bigger number of shares available could end up in more liquidity for the assets, which may enhance trading and lower the bid-ask spread. Raising a stock's liquidity facilitates transactions for purchasers as well as sellers. Because their purchases will have less of an influence on a more liquid asset, this can let corporations repurchase their stakes at a lesser cost.

Although a split should not influence the share price in principle, it frequently results in new interest from shareholders, boosting the stock price. While this influence may fade with time, stock splits by blue-chip businesses are an optimistic signal for investors. Several may interpret a stock split as a firm desiring a larger future runway for expansion; as a result, a stock split often signals executive-level optimism regarding an organization's prospects.

Most of the finest firms' share prices often return to the amounts at which they formerly divided the shares, resulting in another stock split. Walmart, for example, divided its shares 11 times on a 2-for-1 basis between its initial public offering in October 1970 and March 1999. Barring any further acquisitions, an investor who purchased 100 shares in Walmart's first public offering (IPO) would have watched that holding rise to 204,800 shares over the next 30 years.

The drawbacks of a stock split

Not every aspect of a stock split benefits the firm. A stock split is a costly operation that involves legal control and must conform to regulatory requirements. The corporation wanting to split its stock must pay a high price to maintain its market capitalization worth.

A stock split is not worthless but does not influence an organization's basic position and hence does not produce more value. Some people relate stock splits to slicing a piece of cake. It makes little difference if the dessert is sliced into 10 or 20 pieces if it tastes bad.

The detractors of stock splits believe the activity has an opportunity to attract the incorrect type of investor. Imagine a given company shares, which are worth hundreds of thousands of dollars. Many investors in the general public might be ready to cover the firm's shares if the owner divided the stock. However, a firm may purposely not divide its shares to keep stock ownership exclusive.

Finally, there are consequences to purposely lowering the organization's share price. Stocks on public exchanges like the NASDAQ must trade at or above $1. If an organization's stock price falls below $1 for thirty consecutive days, it will be given a conformity warning and will have 180 days to recover compliance. It faces delisting if the organization's stock price does not satisfy the minimum pricing standards.

Comparing stock splits and bonus issues

A bonus issue is comparable to a forward split in that both phrases include increased share volume and a fall in price. Furthermore, these words show how well the organization performs in the market. For instance, when a corporation allocates stocks from its savings, it demonstrates its excellent financial health. Furthermore, a stock split happens when the price rises, demonstrating the company's significant market presence.

A bonus issue occurs when a corporation issues more shares to current investors without paying dividends. Instead, the excess shares are distributed from the firms' free reserves. A share split, on the other hand, refers to separating the current company's shares.

The nominal value of the stocks is identical in terms of trading for the bonus issue. Furthermore, current stockholders receive the additional shares for free. On the other hand, stock splits result in a fall in face value in an equivalent ratio.

Does a stock split have an impact on my taxes?

No, it does not. Under current US law, the extra shares are unlikely to end in taxable income. Every share's tax basis after the stock split will be half the amount before.

Is stock splits beneficial or detrimental?

Stock splits are typically performed when a company's stock price has increased to the point where it may constitute a challenge to new shareholders. Consequently, a split is frequently the outcome of expansion or future growth potential and is a good indicator. Furthermore, the price of a newly split stock may rise if the reduced nominal stock prices attract prospective shareholders.

Does the stock split increase or decrease the company's value?

Stock splits do not affect intrinsic value. The split raises the number of outstanding stocks, but the organization's total worth remains unchanged. The stock price will immediately fall to ruminate the firm's market capitalization following the split. If a firm distributes dividends, the payout per share is changed to maintain the same overall dividend payments. Splits are also non-dilutive, meaning that stockholders maintain the same voting rights.

Are stock splits essential, given the popularity of fractional share investing?

Some analysts believe that as fractional investing grows more popular and ubiquitous, stock splits will not be that essential since fractional shares enable you to participate in a firm at nearly any price point.

Clients may already acquire fractional shares of particular stocks and exchange-traded funds (ETFs) through trading applications like Robinhood, Stash, M1 Finance, and SoFi Invest, especially established brokerage firms like Charles Schwab and Fidelity.

Conclusion

Stock splits are when a firm raises the number of shares it issues, lowering the stock price per share. The separation occurs due to a considerable increase in stock prices, making it impossible for shareholders to spend on them. Nevertheless, lowering the expenses makes it easier for investors to purchase the firm's shares, and they may continue to trade them despite their growing value. Even though the shares are divided, the total cost is equivalent when the cost per share is included. As a result, an existing trader's pre-split stock price will stay the same after the split with a high number of units.