Your money: Understanding stock splits

Stock split: two words that are virtually guaranteed to prick up the ears of most investors. And so far, 2022 has been a banner year for splits – with Tesla, Amazon, Google, and Shopify each issuing additional shares.

But just what does that mean? And is a stock split always a good thing for investors? Let’s take a look.

First, what is a stock split?

A stock split is a corporate action that adjusts the number of outstanding shares in a company to either increase or decrease the price per share.

There are two broad categories of stock splits: forward and reverse.

In a forward stock split, the company increases the number of shares to reduce the per-share price of their stock. A company's board of directors can choose to split their stock by any ratio; 2-for-1, 3-for-1, 5-for-1, etc. Although the number of outstanding shares increases, there is no change to the company's total market capitalization since each share's price also splits. Each share is worth less since it now represents a smaller portion of ownership in the company. In other words, the size of the total pie remains the same – it's simply been sliced into more pieces.

A reverse split is just the opposite – in a reverse stock split, the goal is to increase the per-share price of the stock by combining multiple shares into a single more valuable share. For instance, if a stock is trading at $1 per share and the company institutes a 1-for-10 reverse stock split, investors would receive a single share with a value 10 times higher – in this case, $10 – for every 10 shares they owned. This approach is often used by companies to cash out shareholders who hold fewer than a specified number of shares.

Forward splits are by far the most common, in part because the new, lower price per share makes it easier for average investors to obtain the stock. With a forward stock split, the board of directors is essentially hoping that increased interest and access to the stock will lead to more trading – and, as a result, an uptick in the price.

In the short term, this new interest can build momentum since average investors can now invest in a company that was previously too expensive. But in the long run, the share price will typically come back down to reflect actual performance. There's no guarantee that a stock split will make a company's shares go up in value.

A few recent examples of forward stock splits include:

Tesla: During the company's annual meeting on Aug. 4, Tesla's shareholders approved a 3-for-1 stock split. That split occurred after the market closed on Aug. 24. (Shares of Tesla closed at $891.29 on the 24th and opened at roughly $302 on Aug. 25.) Tesla went through a 5-for-1 stock split in August 2020, making this the second Tesla stock split in just two years.

Amazon: In March, Amazon announced its first stock split since 1999. The 20-for-1 stock split (accompanied by a $10 billion stock buyback) went into effect on June 6. Shares were worth $2,785 at the time of the announcement – a gain of more than 4,500% since the 1999 split. The June 6 split led to a share of Amazon selling for less than $1,000 for the first time since 2017.

Alphabet: Alphabet (the parent company of Google) went through a 20-for-1 stock split after the market closed on July 15. That represented the tech giant’s second stock split after its 2-for-1 split in 2014 and reduced its trading price from about $2,200 to approximately $110 per share. (But the share price has suffered since then, hitting a 52-week low of $96.87 for its class A shares on Sept. 27.)

Shopify: Shopify completed a 10-for-1 stock split after the June 27 trading session. While e-commerce giants like Amazon and Shopify certainly benefited from online consumer spending during the pandemic, there is concern over the impact today’s high inflation may have on online retailers.

So are stock splits a good thing?

Stock splits don’t add or subtract value. A forward split increases the number of outstanding shares, but the company’s overall value does not change. Generally speaking, forward stock splits are done when the stock price of a stock has risen to the point that it’s unrealistic for new investors. So a split is often interpreted as a positive sign – indicating either current or potential growth in the wake of new investors. (That said, stock splits are not universally loved. A perfect example is Berkshire Hathaway CEO, Warren Buffett. Even though A shares of the company now trade for over $400,000 each, he has refused to split those shares.)

The bottom line: While investors often react enthusiastically to stock splits in the short term, it's important to remember that investing is about assessing a business's overall performance. A stock split should not be the primary reason for buying a company's stock. Remember that the split does not affect the company's market capitalization. While there are any number of reasons a company may split their stock, none of them change the business fundamentals. So don’t try to time the market, don’t invest in anything you don’t understand, and don’t be afraid to ask for help from a qualified wealth adviser.

Jennifer Pagliara, CFP, CTFA, is an executive vice president and financial adviser at CapWealth. For more information, visit capwealthgroup.com.