A Beginner’s Guide To Stock Splits And How It Affects You

Stock markets are extremely volatile. If you miss the momentum, you lose the opportunity of scaling-up your portfolio’s valuation. As a new investor, it is prudent to build your financial expertise in various aspects of this industry.

This blog talks about the stock split – an interesting notion that involves the interplay between a company’s market capitalization [market cap] and its investor sentiments.

What Are Stock Splits?

Stock Split, or Forward Split, is an activity undertaken by a listed company that divides its existing share of stocks into multiple denominations.

Here, the shares outstanding, i.e., a company’s (current) stock volume held by its investors – increases, but the market cap remains unchanged. This is because the actual dollar value of the shares remains fixed post-split.

For example, if 1 stock for ABC Org was traded at $25 earlier, the same shares are split into 2 for $12.5 each.

How Do Stock Splits Operate?

Let’s understand this operation with an example:

Publicly-traded, ABC Org has announced a 2-for-1-stock split. Before the split, investor X held ABC’S 100 shares at $50 each. X’s investment for this company stands at $5000 in its portfolio.

Post-split, the total value for X’s shares is unchanged at $5000. But, X now owns 200 shares for $20 each – since the price of the stock is marked down from 50 to 20.

The most common split ratios are the 2-for-1, 3-for-1, 5-for-1, and 100-for-1. For a 3-for-1 stock split, it implies that the owner who (earlier) held 1 share of this company now holds 3 shares for the very same stock.

Similarly, for a 5-for-1 stock split, an investor (earlier) holding 1 share now holds 5 shares (at marked-down prices per stock).

The takeaway:

The market cap of outstanding shares remains unchanged. 

Companies That Undertake Stock Splits

Publicly-listed companies, including the blue-chip stocks, undertake these splits on account of various reasons (listed below).

Recent examples to corroborate this statement:

– Apple, on August 31, 2020, split its stock 4-for-1. Meaning, every investor holding 1 share will now hold 4 shares of Apple – leaving the market cap unchanged. The price of each share, as of August 28, 2020, was $499.23.

The value was marked down to $127 per share. This greatly increased market liquidity, which in turn, encouraged promising investor participation.

Is this the first time Apple announced a split like this? 

No. This was recorded as its fifth split since its IPO on December 12, 1980. 

– On the same day, Tesla announced its 5-for-1 split. The earlier traded price on August 28 – $2,213 slid down to $442 each on August 31.

What Motivates Stock Splits?

Stock splits are expensive. Naturally, there ought to be some underlying incentives that boost a company to plan & execute such moves. Let’s decode each of them here:

1. Increase Affordability For Investors

One of the major reasons for stock splits is a company’s (discouraging) exorbitant share prices – due to acquisitions or new product launches – that pushes away active investors.

However, with the split, since the math remains unchanged for the company – the comparatively expensive stock is now available at affordable rates – encouraging greater investor participation.

2. Facilitates Greater Liquidity

Lower Prices Per Stock + Greater Volume of Traded Stocks = Increased Liquidity 

To narrow down the gap between the bid-ask spread, companies can undertake stock splits. The bid-ask spread is essentially the difference between the highest price offered by the buyer and the lowest price acceptable to the seller of the stock.

Increased flexibility encourages affordability. This reduces the spread without influencing the share price by a significant margin.

3. Favorable Impact On Stock Price

A favorable stimulus for organizations – brought by the increased investor participation on account of lower prices and increased trading. Sometimes, this augments the current (lower) prices to reach favorable numerics.

Acknowledge These Important Dates

1. Announcement Date

The day the company executives publicly announce the details of the split – split ratio and the future timeline for the entire process.

2. Record Date

This is the date by which an investor, in order to be eligible for the benefits of the split, must own certain shares of the company in their portfolio.

3. Effective Date Or Split Pay Date

The date at which stocks undergo their respective split ratios, as stated on the announcement date.

4. Split Ex-Date

The date following the effective date. From this day onwards, trading occurs at the new marked-down share prices.

Shareholders may either see the “extra” shares immediately or may have to wait for a few days for them to be reflected in their portfolios.

Advantages Of Stock Splits

This move is undertaken with the twin intent of benefitting the investors & a company’s stock traded volume (& value). There are several advantages:

1. Increasing Liquidity

Facilitates increased trading at narrow bid-ask spreads.

2. Portfolio Adjustment Easier

Managers can sell and adjust their portfolio holdings more conveniently at a lesser cost.

3. Increases Share Prices

Greater investor participation may often result in increased share valuations.

4. Facilitates Put Option At Cheaper Price

A put option is the right of a buyer to sell his asset at a pre-determined strike price in a particular time frame.

With the split, selling can be easier & cheaper for both parties bounded by the contract.

These benefits are greatly experienced with commission free trading platforms like Alpaca. Simply because, as an investor, you save a good deal of money that would otherwise be incurred as brokerage fees.

As with every stock market notion, there are certain caveats to look out for:

Investors who intend to opt for a wash sale. The new (reduced) price may incentivize selling at a loss. However, if you repurchase the asset back within 30 days (before or after), you lose the benefits from tax offsets on previous gains.

Reverse Stock Splits

Opposite of forward splits – reverse splits lead companies to reduce their outstanding shares and, in turn, increase the price per share. A major reason for this is the fear of getting delisted from stock exchanges on account of not meeting the minimum listing price.

Final Words

Splitting is a fruitful move that benefits every participator in the trading industry. For investors, it is vital to regularly keep a tab on stock valuations whilst for companies, it is prudent to assess the benefit-cost ratio when making such decisions.

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