We take a brief look at what exactly stock splits are. Why do companies do them? How does the market react? More importantly, what does this mean for you as an investor?
““Is the market high only because of some irrational exuberance — wishful thinking on the part of investors that blinds us to the truth of our situation?” - Robert J. Shiller
With the purpose of increasing liquidity, a forward stock split is when a company divides the existing shares of its stock into multiple new ones. Although the number of stocks increases by a specific multiple, market cap remains roughly the same as the overall value of the company is neither diminished nor increased. This is because when a stock is split, the cash value of however many stocks that result from the split are equivalent to the value of a single share prior to the split.
Alternatively, reverse stock splits clump shares together. For example in a 1 for 10 reverse split, every ten shares of a security amount to one share after a split is decided by a company. Similar to its forward cousin, this kind of stock split does not change the market cap of a company on the exchange, but instead actually increases the price of a single stock as a fixed number of them pre-split are merged into one. The immediate effect, of course, is that a company’s price-per-share increases rather drastically.
Companies split stocks when their stock become expensive and highly coveted. In the case of the titans of industry in Apple (NASDAQ: AAPL) and Tesla (NASDAQ: TSLA), the aim is to make the acquisition of stocks by retail or new investors more appealing. They do this by splitting a single stock into multiple, effectively decreasing the price of ownership. This increases the number of potential shareholders. Human psychology can be attributed to our tendency to interpret this perceived “discount” as opportune.
What does this mean for your portfolio? If you own stocks in a company planning on splitting stock it is essential to understand what factors coincide with splits to drive the value of your investments up or down. Let’s take a look at Tesla as an example. At the time of publishing this piece, the American electronic vehicle maker is being traded at around $2500 per share. The company will be issuing a 5 for 1 stock split. This means that at the end of market hours on the day of the stock split shareholders will have their shareholdings multiplied by 5, with each share now valued at around $500 per share instead. This in effect makes current shareholders feel as though they are in possession of more assets in the company, when in reality the value of their holdings has not changed. This isn’t to say that the price per share remains entirely stagnant after a stock split.
In theory a split should have no effect on a security’s price. However, in reality the subsequent perceived decrease in price per share can result in freshly formed stocks increasing in price in the short term as trade volume goes up. This is the intended outcome for company executives. By lowering the price of entry to a market for a stock so highly successful that it’s price eventually becomes seen as “too expensive” by those at the helm themselves, execs hype up their stock’s potential for growth. In addition to a lowered bar for acquisition, this “democratization” of a stock make potential investors more excited to buy stocks in the company. Consequently as more trading occurs, the perceived value of a security goes up, constituting a short-lived positive feedback loop.
Inversely, companies use reverse stock splits to shore up low prices for under-performing securities and to decrease the number of their outstanding shares available in the market. Consequently this increases the price of acquiring a single stock in the company and theoretically increases demand. Companies typically do this when there is fear of potentially being delisted from their corresponding exchange.
A major underlying question remains: What does this mean for investors with fractional shares? This incredibly enticing form of retail investing has been on the incline in recent years as brokerages like Schwab, Robinhood, Fidelity and SoFi (to name a few) allow their clients and customers to buy percentages of stocks as opposed to whole sums. The resulting effect is that whereas in the 1990s at least a hundred companies a year issued splits, we now see single-digit occurrences. Splits are now typically done by companies that see an astounding level of growth characteristic of the tech sector. Depending on your brokerage you could see the effects of the split translated directly to your portfolio. The overall value of your investments will not immediately change, but the percentage of stock you own will be multiplied by the split factor.
From our earlier example, let’s assume you owned 0.5 stocks of Tesla at today’s average price valued at $1250. After the 5 for 1 reverse split you would own 2.5 stocks each valued at $500 (with the half stock now valued at $250), with the sum value of your investment remaining $1250. Some brokerages sell off fractional shares and place the money into customers accounts as they will only split full shares. If you own fractional shares, it is probably best to contact your brokerage before a split and confirm whether your fractional shares will be sold or split.
Reverse splits on the other hand consolidate shares for companies. Take the case of struggling energy company TechnipFMC PLC (NYSE: FTI). Valued at $7.88 per share as of this writing, the company could hypothetically decide to shore up its stock price by issuing a 1 for 3 reverse stock split. This would translate to a single share being valued at $23.64 post-split. For those with brokerages that handle fractional shares, assuming no extra shares were bought before the split, the value of you investment would remain the same but you would now own 1/3 of a stock. By and large, for this kind of split brokerages are more likely to cash out than translate customer holdings to fractional shares.
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