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You may have seen some big names like Apple and Tesla in the news for their stock split, but companies perform stock splits all the time. It’s not uncommon for a company to want to split shares or even reverse their split.
But why would a company undergo a stock split?
How should it affect your investing strategy?
We’ll break down all this, and more, in this guide to stock splits.
What is a Stock Split?
Stock splits occur when a company’s board of directors decides to split stocks in half.
If you own the stock, you may not realize this has happened in your investment portfolio, because the value of the stock does not immediately change. But instead, you will see the number of stocks you own increase.
Let’s start with a simple theoretical example to illustrate how a stock split works.
Company X opts for a 2-for-1 stock split of their company. You own a single $1,000 share of this stock, but after the stock split, you now own two shares after the stock split.
The market values your two shares at $500 each immediately following the split.
Apple chose to do a 4-for-1 split in August 2020, and then Tesla went for a 5-for-1 split in the same month.
But why do companies decide to split stock?
A stock split makes a company’s stock more accessible to those who haven’t invested in a company.
It allows for more people to buy shares due to the lower price of the divided shares.
Advantages of a Stock Split
There are several advantages of a stock split.
Stock splits benefit investors who haven’t bought shares of a company. Lowering the cost of stock allows a larger range of people to invest in the company.
If you already own shares in a company, the advantages depend on the company’s financial state. Initially, your stocks don’t change value after a stock split.
But if the company is in a good financial place, there will be greater demand to purchase stocks due to the lower cost.
If this happens, it will drive up the value of your current holdings.
Disadvantages of a Stock Split
Though a stock split has several advantages, there are disadvantages.
Stock splits create greater volatility for the company’s stock.
The lower cost of the stock invites tumultuous investors like day traders to invest in the company.
These investors bring volatility with their short-term investment tactics — this can cause the value of the stock to rise and fall.
Stock splits can affect current and future investors. Current investors will have to weigh the risks of riding out the uncertainty of a more volatile stock, and the unpredictability may deter potential investors from investing altogether.
Types of Stock Splits
Stocks can split in two different ways — forward and reverse. We’ll break down each next.
What is a Forward Stock Split?
A forward stock split is the traditional stock split that we mentioned above — it’s when a company splits a stock into smaller parts.
What is a Reverse Stock Split?
Reverse stock splits are the opposite process compared to forward stock splits. Companies can reduce the number of stocks it offers so that the cost of each stock increases.
It doesn’t change the market capitalization but divides the number of stocks available.
Companies do reverse splits when trying to maintain their status on certain exchanges due to minimum requirements.
For example, you could own two shares of a stock valued at $500 each. When a reverse stock split occurs, the company could set it at a 1-for-2 reverse split. This means that you now own one share at $1000.
Should You Buy A Stock Before or After a Stock Split?
It depends on your investing situation.
It’s important to remember that the company’s value remains the same immediately before and after a stock split.
A stock split shouldn’t matter if you plan on investing for the long haul. But for investors who haven’t been able to afford a share of the company previously, a stock split is a great time to invest.
The Bottom Line: Stock Splits
Stock splits occur when a company decides to divide its stocks. The process divides the quantity of stock and also the share’s value.
Companies typically perform stock splits to make stocks more accessible to a greater number of investors.
Stock splits don’t significantly affect long-term investors of a company, but they do encourage new investors to take the plunge. You may see stock values increase if demand is present in the lower-cost stocks.
But keep in mind that many factors go into whether or not you should invest in a new stock besides a stock split. To learn more about stock investing fundamentals, here's a free guide.
