An Investor's Guide to Stock Splits

In July of 2020, when Apple (AAPL) announced that they would be splitting their stock, it was big news. It really shouldn’t have been though. Splits aren’t that rare -- case in point, Tesla (TSLA) announced a stock split of their own in the wake of Apple's announcement. Since Apple's news, there were forty-eight splits of exchange-traded stocks. And yet, each time it happens to a high-profile stock, I hear the same puzzlement and misunderstanding from investors. There seems to be a need for a simple explanation of what splits are, what they do, and, more importantly, what they don’t do.

Here is a handy guide to stock splits.

The Big Misconception

Let’s start with the most common misconception. When a stock splits, it doesn’t affect the value of your holding. When Apple made their announcement, my son came to me with a big smile on his face. “Wow” he said, “I just made a ton of money!” His reasoning was that the 5 shares he held in Apple were about to become 20 shares. He thought he had made 300% overnight.

That isn’t true, though.

The thing to remember is that a stock’s price reflects the value of the company that it represents, not the value of the stock itself. For example, company A, with stock that trades at $10 and with 1 million shares in circulation would be valued at $10 million ($10 per share of stock x 1 million shares). Company B, with a $1000 stock, but only 1000 shares out there, would be valued at $1 million.

So in other words, when a stock splits, that valuation doesn’t really change, but the number of shares issued does. As a result, the price of each share will change.

In the case above, my son would indeed have four times the number of shares he had before, but each would be worth one quarter of its previous price, say $100 per share instead of $400 per share. The number of shares he owned changed, but so did the price of each of them. His roughly $2,000 dollar investment was still worth $2,000 even though he will now have four times the number of shares.

So Why Do Companies Bother?

The obvious question that follows from that is why companies bother to split their stock if it doesn’t change the valuation of their company, or the value of their investors’ holdings.

It is really all about appearances. Splitting the stock gives the impression of affordability to small investors. Now that most brokerage platforms are happy to trade in fractions of a share that shouldn’t be such a big factor, but the psychology of it will probably persist. AAPL at $100 just looks better value than AAPL at $400, and certainly is more appealing to a lot of small investors than, say, Amazon (AMZN), at over $3,000 per share.

That isn’t the only reason, though. A split sends a message about past and future growth. “Look,” it says, “our stock has gained so much that we have to make an adjustment. What strong growth!” It also does add to the stock’s liquidity, making it easier to trade. In the specific case of Apple, that likely wasn't an issue since they already had 4.28 billion shares outstanding, with 50 to 100 million of them being traded every day.

A stock split is basically a form of corporate bragging. It suggests that the stock has gained too much. Something has to be done to bring the share price back to Earth!

Reverse Splits

There is, however, another type of split that usually sends the opposite message. This is known as a reverse split.

In a reverse split, the number of shares outstanding is reduced rather than increased. A regular split might be expressed as say 4:1, meaning that investors receive three additional shares for each one they hold, giving them four shares in total, while a reverse split would be something like 1:4. Investors there would, post-split, hold one share for each four they held before the split.

Like a regular split, a reverse split does nothing to the value of an investor’s holding in the company but has some implications, nonetheless.

If a regular split screams success, a reverse split usually says the opposite. It is normally done after a big, sustained drop in a stock's price and, as such, it can be seen as an admission of failure, or at least poor performance. So, why would any company do that?

The main reason is to maintain the stock’s place in an index or an exchange. Indices and exchanges have rules about what can be included. In many cases, for example, a stock must be priced above $5 per share in order to be listed. Those rules are there because when a stock’s price is extremely low, it can become extremely volatile, reducing its value as an indicator of overall stock moves. That volatility encourages speculative trading which, in turn, increases volatility, which encourages speculation, and so on and so forth.

That reduction of speculative trading was the stated reason for one of the most high-profile reverse splits in recent memory, when Citibank (C) announced a 1:10 split in 2011. The financial crisis had brought the once high-flying Citi stock down below $5, and ten percent moves in a day had become commonplace. Of course, it also didn’t help that the stock was below the $5 threshold, and the reverse split saved Citi the embarrassment of being removed from indices.

The Dates

When a company announces a stock split, they give out two dates that are important to shareholders, a record date and an ex-date. You must hold the stock at the close of business on the record date to be eligible for the split, while the actual split itself and the adjustment to the number of shares in your account takes place on the ex-date.

With regular splits, there is usually a week or two between the announcement and the record date, then another gap between that and the ex-date. Reverse splits, however, usually take effect immediately on the announcement. Again, that points to the intended effects of a split. The company wants to give investors time to appreciate the positive implications of a regular split but doesn’t want traders to have time to dwell on what a reverse split says about the stock.

What Investors Should Do?

This is probably the easiest question about splits to answer, because most of the time, investors should do nothing at all.

You may want to reconsider a stock you own if it undergoes a reverse split, as they often encourage more selling after the action. But with a regular split, sit tight until something changes. There is a good chance that immediately following both the announcement and the ex-date, the stock will get a small boost, so if you were thinking of selling just before an announcement, you may want to hold off a little before doing so.

Stock splits are much more common than most investors think, although they are also less impactful. The most important thing to keep in mind, though, is that they don’t change the value of your holding, although they may have some influence on the stock’s performance for a while after they happen. Understand that and splits become a little less intimidating.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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