Everything you need to know about stock splits

Electric car maker Tesla and Silicon Valley tech giant Apple took the US market and the broader investment world by storm when they made the surprise decision to split their stocks a few weeks ago. Apple decided to enact a 4-for-1 split, while Tesla approved a 5-for-1 split to make the stocks "more accessible to a broader base of investors".

Investors cheered the news, pushing both stocks, already on a tear, higher in an extended rally at a time when the pandemic-hit market is trying to rebound from the March carnage. This was Tesla’s first ever split, whereas it was Apple’s first split in six years.

When Apple and Tesla stocks began trading on September 1 for the first time after their splits, they picked up exactly where they left off: clocking nearly 4 per cent and 12 per cent jumps, respectively, for the day.

If you’re new to the investing game and wondering what this numerical gymnastics is all about, here’s a handy primer to bring you up to speed with the inner workings of a stock split.

What is a stock split?

A stock split is when a company issues new shares and distributes them to existing shareholders. “A 4-for-1 stock split, for instance, would mean that current investors with one share receive three additional shares so that following the share split, they now own four shares,” says Chris Davies, a chartered financial planner at The Fry Group.

Analysts are quick to point out that a stock split doesn’t make shares cheaper. The best way to understand it is to use a pizza analogy. A Dh40 16-inch pizza does not become cheaper when split in eight slices of Dh5 apiece.

“The total aggregate dollar value of your position is the same, you just now own more shares to get to the same total,” says David Whiston, equity strategist at Morningstar Research Services. “A stock split has no impact on the intrinsic value of the company.”

All a stock split does is change the number of outstanding shares of a company’s stock without altering the shareholders’ ownership percentage in the company. While the move does not alter stock valuation, “what can happen is retail investors increase demand for the stock and the stock moves up on the news, like Tesla did in a massive way”, says Mr Whiston.

Why do companies do it?

It is widely believed that companies perform stock splits to “democratise” ownership of their shares. Stocks that have had a wild run-up in prices tend to squeeze out retail investors who may not be able to afford it. By undertaking a stock split, companies try to make their shares more attractive and accessible to retail investors. On a more psychological level, it also fuels the notion among existing shareholders that they now have “more” stocks of a company than they did previously.

“As a share price rises, smaller investors may not want to commit such high levels of investment in a single share if it is valued at hundreds or even thousands of dollars,” says Mr Davies. “Therefore, companies with very high individual share prices may be missing out on capital from retail investors.”

In addition to making the stock appealing to a wider shareholder base, a split may be done in order to “gain admittance to the Dow Jones Industrials index, because that is a price-weighted index, so it won’t want one of its 30 members to have a large share price”, says Mr Whiston.

A share price is not relevant for the inclusion to the S&P 500 index, though, as it’s a market-cap-weighted index.

It is worth noting that “some companies have not done splits, like Berkshire Hathaway, and to buy one share of Berkshire Hathaway, you need more than $337,000 [Dh1.2 million]”, says Brad Gastwirth, chief technology strategist at Wedbush Securities.

It is also argued that the introduction of fractional share ownership provided by online brokerage platforms – such as those offered by Robinhood, Charles Schwab and Fidelity – has rendered the rationale for a stock split obsolete. Some industry experts point to fractional investing as the reason why companies are no longer splitting their stocks as they did in the 1990s.

Are stock splits making a comeback?

Stock splits have been out of vogue in recent years. While 1997 saw 102 stock splits among companies in the S&P 500, there have only been a handful so far this year. However, with Apple and Tesla announcing stock splits within days of each other, speculation is rife that others may follow suit.

“Hard to say what all the tech firms will do, but Amazon and Alphabet have had a long time to split and don’t seem interested,” says Mr Whiston, noting that “both Apple and Tesla had seen large run-ups” before the split.

A slew of new stock splits could be in the cards if those of Apple and Tesla prove successful, says Mr Davies. “Amazon in particular has not split its stock since before the dot-com bubble in the late 1990s,” he points out. “As such, its high share price may limit investors’ ability to purchase its shares.”

Amazon’s lofty stock valuation, he adds, may also be preventing it from being listed on the price-weighted Dow Jones Industrial Average as the stock’s price may dominate the index and cause significant volatility.

Throughout the 2000s and 2010s, companies largely shied away from stock splits, viewing their share price rises as a status symbol, says Mr Davies. The Apple and Tesla stock splits herald a shift, though. “Shares have been increasing over this time and fractional ownership is only available on certain accounts. Share splits can thus provide the opportunity for greater retail client inflows into a stock,” asserts Mr Davies.

Mr Whiston of Morningstar contends the share split does nothing on the day of the split to increase wealth, but concedes that “the company that continually goes up and splits is a good investment and tech seems to be the industry where that happens”.

Why should investors care?

Regular stock splits don’t mean anything in particular. While the individual unit costs less to buy after the split, the fundamentals of a company – from the valuation metrics to price-to-earnings ratios and the market cap – remain unchanged. The perception of affordability among a larger base of investors, though, could add value to a company’s equity.

The fact is corroborated by the whopping 13 per cent jump in Tesla shares the day after its 5-for-1 split was announced. “Nothing fundamentally changes, but smaller investors may now be able to invest, or at least feel more comfortable investing, which can benefit the stock,” says Mr Davies.

There is another reason for investors to keep a close eye on stock splits. It is particularly relevant to those who invest in index funds and exchange-traded funds (ETFs) that track indices, especially the Dow. As the index is price-weighted, Apple’s stock split diminished the company’s oversized influence on the benchmark. Apple went from having the biggest weighting in the index to 16th, post-split. This has implications for Dow 30 investors as their returns will depend considerably less on Apple’s performance going forward.

“Some commentators would argue that a share split is a non-event as it does nothing but change the share price and number of shares available, however, they can impact stock performance,” argues Mr Davies.

A stock split is also a measure of confidence a company has in its growth prospects. “One factor that is often quoted is that a share split can be viewed as a positive from the management of a company as they would be unlikely to split a stock that they thought would fall,” Mr Davies notes.

What comes after the split?

Some market observers say there's evidence that a split may represent a "buy" signal. Notably, between 1990 and 2015, stocks averaged a hefty 21 per cent return during the 12 months following a split, compared to a 9 per cent gain for the S&P 500, as per the S&P Dow Jones Indices. History shows Apple typically outperformed the S&P 500 by nearly 8 per cent in the six months following its stock splits in 1987, 2005 and 2014, according to Evercore ISI Research.

“Numerous studies have concluded that, historically, shares that have split have beaten the market over the following one and three years,” says Mr Davies. “This could be caused by the publicity of the split, the belief that the split conveys important private information on future performance, or from the increased investment from smaller investors bidding up shares further.”

That being said, there is a significant amount of information to factor into share prices and a share split alone is not enough to guarantee future performance, warns Mr Davies, stressing the need for “a broadly diversified approach [which] would typically mean that a small section of your portfolio would be in these companies [that split their stocks] and others which are yet to announce stock splits but may do in the future”.

When stocks split in reverse

A reverse split is a reduction in the number of outstanding shares. It’s the exact opposite of a forward stock split. In a 1-for-4 reverse split, for instance, 400 shares of a company would be equal to 100 shares after the split. Accordingly, the price of each new share would also be worth four times the pre-split price. If the stock was worth $4, it would be worth $16 after a 1-for4 reverse stock split.

“One should be wary of reverse stock splits,” says Mr Gastwirth, noting such a move “is always a red flag”.

Companies that have a falling share price sometimes attempt to protect their shares by enacting a reverse share split. “This may be used when a company’s share loses a significant amount and causes concern that it may not be able to be traded on its current index at such a low price,” says Mr Davies.

However, a reverse split may not be enough to salvage the situation. “Research has shown that the reverse share split can add increased downward pressure on a share’s price,” Mr Davies cautions.