What is a Stock Split, and Why Do Companies Do Them?

You have probably heard about stock splits more than once over the last 3 weeks. Two high profile splits have been announced- Apple and Tesla, so there has been a lot of talk about them. Stock splits are simple and for many investors, there is no impact on their portfolios even if you hold these stocks. When a stock splits you will have more shares than you did before, but the share price will be lower. It is common to see 2-for-1 or 3-for-1 stock splits, but it can be done in any number of ways.

Apple announced a 4-for-1 split when it reported third-quarter earnings at the end of July that will take place on August 24th, 2020. This means that if you had 1 share of Apple you would now have 4, or if you have 4 you would now have 16. However, the price of 1 share will be ¼ what it was before the split, so the total dollar amount you owned of Apple will not change and neither does Apple’s market cap.

It’s important to remember that the underlying value of the company does not change during a stock split. So, why would a company bother doing a stock split? One of the most common reasons is to adjust the price per share down to a level where people are more comfortable buying additional shares. Some investors may not be able or want to pay $400 for a share of Apple. Now that a share of Apple is only $100, it may encourage some to purchase it. There is less of a case nowadays for stock splits given that many brokerages are offering fractional shares, but there are still many brokerages that do not offer this service. As more brokerages allow for fractional share purchases, it will be interesting to see if fewer companies decide to do stock splits.

Why do Companies do Stock Splits

Investor behavior and psychology are not the only reasons however to implement a stock split. With a higher number of shares outstanding, the stock may see greater liquidity. Increased liquidity makes buying and selling shares easier for the investor and increases flexibility. There are also certain scenarios regarding employee stock options that may make stock splits desirable.

Occasionally, companies perform reverse stock splits- which are, as you may have guessed, the opposite of stock split. This is when a company divides the number of shares and the share price increases. If a company issues a 1-for-4 reverse split, you will receive 1 share for every 4 shares you held. The price per share will increase, so in the example, if the company’s stock was trading at $2 a share it will now trade at $8 a share after the 1-for-4 reverse split, but there will be only a quarter of the shares that there were before. Reverse splits also do not change the underlying value of the company. Reverse splits are usually implemented to prevent a stock from being delisted from an exchange due to the low price or to be seen in a more positive light by investors.

In general, stocks splits don’t make much of a difference for investors. In the case of Apple, however, the stock split will significantly impact the future performance of the Dow Jones Industrial Average- one of the most closely followed indices. While most indices are market cap-weighted, meaning the larger the company, the larger its impact on the index, the Dow is price-weighted. This means the higher the share price, the larger the impact on the performance of the index. Since Apple is currently a $450+ stock, it currently has the highest impact on the performance of the Dow. After the split, Apple will fall to roughly 17th on the list. As one of the largest companies in the world, this doesn’t make much sense. The moral of the story? The Dow is a bit of a historical relic at this point.