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What Is a Stock Split and How Does it Affect Investors?

October 02, 2020 09:40 UTC

Stock splits, or share splits, have been in the news quite a lot recently. You have probably read about listed companies, like Apple and Tesla, splitting their shares. But what exactly is a stock split? Do stock splits matter to traders and investors? And can one construct a trading strategy related to share splits?

In this article we will be looking at those questions and more.

What is a stock split

What is a Stock Split?

A stock split occurs when a company decides to increase the number of shares it has outstanding and distributes the new shares to existing shareholders in proportion to their current holdings.

Let's illustrate this with an example:

  • Corporation XYZ has 100,000 shares outstanding
  • You own 1,000 of these shares, or 1% of the total shares outstanding
  • Current share price of XYZ = £1
  • Your total share value = £1,000

XYZ then announces that, on the first trading day of November, it is going to split its shares on a 5 for 1 basis.

Therefore, on the first trading day of November, the following will be true:

  • XYZ will have 500,000 shares outstanding (100,000 x 5)
  • You will own 5,000 shares (1,000 x 5)

Every other shareholder will also receive additional shares in proportion to their holding and you will note from the above, that even though you now own more shares, you still only own 1% of the shares outstanding.

Does a Split Increase the Value of Your Holding?

Unfortunately, the answer is typically "no".

In the previous example, when the last trading day of October comes to an end, stockbrokers and registrars adjust their documentation to reflect shareholders' new holdings. Furthermore, companies like the exchanges, Bloomberg and the Financial Times, whose responsibilities include reporting share prices, adjust the official closing price of XYZ's shares to be 1/5th of the price at close.

Let's say, for simplicity, that XYZ's shares closed at exactly £1.00 per share on the last trading day of October. After the adjustments described above are made, your 1,000 shares, priced at £1.00 each, become 5,000 shares priced at £0.20 each. Therefore, the value of your holding at this stage is exactly the same: £1,000.

Similarly, although the company has 5 times as many shares in issue, its market capitalisation stays the same.

In theory, the total value of any company does not change just because the number of shares outstanding has increased. But is this what happens in practice? Before we answer that question and look at some real-life examples, it is worth looking at what the reasons behind share splits actually are.

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Why Would a Company Split its Shares?

The most common motive for companies to split their shares is to facilitate liquidity in the trade of their shares. This is best explained with a real-life example.

In January 2010 shares in Warren Buffet's company, Berkshire Hathaway's B shares, were trading at almost $3,500 for one share! That meant that if you wanted to invest in the legendary "Wizard of Omaha's" company, you had to find at least $3,500 to buy one share. Not everyone has the ability to do that.

If, conversely, you were an existing shareholder who had enjoyed steady rises in a past investment in Berkshire and now wanted to sell enough shares to fund a $1,500 holiday, you would have had to sell at least one share - generating more cash than you needed and probably more tax liability than you wanted. If you held other shares that allowed you to generate a sum closer to the $1,500 you needed, you would probably choose to sell those instead.

You can see from these two examples that when share prices are too high, trading can become awkward and, therefore, less frequent – i.e., the market for those shares becomes less liquid than it could otherwise be.

Why is Liquidity Important?

Splitting the shares allows potential traders and investors with less than $3,500 to buy shares more easily. It also allows potential sellers to liquidate amounts of money closer to what they really need. So, the increase in shares, translates to an increase in convenience and prompts more trades to take place, making the market for the shares more liquid.

Increased liquidity narrows the spread of the shares and makes owning shares less risky (because they are now easier to sell). This leads to a slight increase in demand and that, in turn, lowers the cost of capital for the company. This is the main incentive for companies to split their shares.

What Happens in a Real Life Split?

In theory, just because a company has more shares in circulation, it should not be worth any more than before.

However, companies that split their shares are, by definition, those with high share prices – those that have seen big rises in the past and whose shares are on a long-term upward trend. The announcement of a split causes more people to notice this.

There is a certain amount of kudos associated with the announcement of a share split, which screams "Hey, look at us. We've been so successful that our share price is too high to trade and we are going to have to do a share split".

Does This Affect the Share Price?

For many traders and investors, a split is a sign of a successful company and, consequently, a buying signal.

In addition, as we have seen, splits tend to generate additional liquidity and this can generate more demand for the shares – reinforcing the upwards effect.

All this means that, in practice, share splits are often followed by increases in the share price.

In the previous example, Berkshire Hathaway implemented a 50 for 1 split for its B shares in January 2010 and this was welcomed by the market with a 5% jump in the share price during the first 30 minutes of trading after the split came into effect. After that, the price resumed its long term upward trajectory at a slightly faster pace than before the split.

Are There More Recent Examples of Share Splits?

Recent examples of companies splitting their shares include, of course, Apple and Tesla.

Example 1. Apple

On the 30 July 2020, with its stock at $380, Apple announced a 4 for 1 stock split. The share price was already on an upward trend but the announcement accelerated the trend and three weeks later the shares were at $497 – a 30% increase. By the 1st September Apple's market-cap reached $2.3Tr., surpassing the value of the entire FTSE100 ($2.1Tr. on the same day).

There are many reasons for Apple's success but its positive share price trend clearly accelerated after news of the split. This can be seen in the chart below, with the vertical red line indicating the date which Apple announced their most recent stock split.

Apple Daily Chart MetaTraderDepicted: Admiral Markets MetaTrader 5 - AAPL Daily Chart. Date Range: 11 March 2020 - 3 September 2020. Captured 3 September 2020. Past performance is not necessarily an indication of future performance.

Example 2. Tesla

The day before Tesla's announcement of a 5 for 1 split on the 11 August 2020, their share price closed at $1,405.30. The announcement saw share prices immediately jump by 7% in after-hours trading. Tesla said it did it "to make stock ownership more accessible to employees and investors".

The company's already buoyant share price increased 57% in the two weeks after the announcement – without any additional news. On 28 August, the last trading session before the split took effect, Tesla's share price closed at $2,213.40.

Roughly 3 weeks after announcing the split, Tesla made a statement that it would raise up to $5bn by selling new shares, underlining the motive behind its share split.

Tesla Daily Chart MetaTraderDepicted: Admiral Markets MetaTrader 5 - TSLA Daily Chart. Date Range: 4 February 2020 - 4 September 2020. Captured: 4 September 2020. Past performance is not necessarily an indication of future performance.

How Common Are Share Splits?

Share splits were very popular during the late 1990s – in 1999 there were more than 85 among S&P 500 companies alone. But they had fallen out of fashion, with only five taking place among this same group of companies in 2019. However, the success seen by Apple and Tesla may encourage other CEOs to consider share splits.

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Trading Stock Splits

As we have seen, share splits highlight a high share price - and thus past success - to a larger audience. They are seen by many as a signal for buying the company's shares, so can lead to immediate positive bumps in prices or acceleration of positive upward trends.

However, the idea of buying physical company shares may not be appealing or accessible for everyone. Although a stock split does reduce the price of a company's individual shares, this reduction in price still may not make it feasible for individuals to profit from this news unless they have an abundance of capital in the first place.

For example, on the 31 August 2020, Tesla's 5-1 stock split took effect. However, the opening share price on this date was still $445.84.

Splits and CFDs

With Contracts For Difference (CFDs) it is possible to take advantage of price movements in stocks, without actually owning the physical stock. CFDs are a financial instrument by which you enter a contract with your broker to exchange the difference in price of an underlying asset between the time the contract starts and ends.

CFDs benefit from leverage, which means that you can open a position without the entire cost of the position. This presents an opportunity to magnify your potential profits, however, it must be used with caution as leverage can similarly magnify any losses.

A further benefit of trading with CFDs is that you can take advantage of not just upward movements in an asset's price, but also its downward movements by short selling.

What Is a Reverse Stock Split and Share Consolidation?

Reverse stock splits, sometimes called share consolidations, are the exact opposite of share splits. They consolidate the number of outstanding shares in the same proportion for all shareholders.

Share consolidations are normally carried out by companies who have seen large drops in their share price over a period of time and are often seen as a sign of a company in trouble.

A Share Consolidation in Action

In March 2017 Bank of Ireland (BoI) announced a 30 to 1 reverse-split of its shares. Before the consolidation BoI had 32bn shares outstanding and, with shares trading at around €0.23; a market cap of around €7.6bn.

The large number of shares was partly the result of capital injected by the Irish government at the time of the 2008 financial crisis, when the bank was in trouble.

Straight after consolidation the shares traded in line with market cap, at €7 each, but they soon resumed their downward trajectory and, by September 2020, they were trading below €2.

The official reasons given for share consolidations are usually practical, "to simplify trading for our shareholders", for example.

But when investors see a "penny stock", they assume the company behind the share is an underperformer. A share consolidation is a good way to hide this, at least temporarily.

In addition to the optics, some US exchanges (NASDAQ, for example) have rules which allow the exchange to delist shares that persistently trade below $1. A reverse split is a quick fix for that potential problem.

Share Consolidation Trading

As we have noted, a share consolidation is usually perceived as a sign that a company is in trouble and often results in a continued downward trend.

Traders who agree with this conclusion may choose to use CFDs to short sell a company's shares once a share consolidation has been announced.

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Final Thoughts

As we have seen above, share splits are a signal that a company has enjoyed increases in its share price and expects more of the same. Share consolidations indicate the opposite.

Many traders and investors use these as prompts to take a position in the company. Others use it as a trigger to take a closer look at a company, to do more analysis before taking a position. The more angles you look at a potential trade from, the more likely you are to succeed.

Although, as we have seen, when a company announces a stock split, it can lead to an increase in share price, this is not necessarily always the case. It is important to remember that a share split itself does not have any effect on the value of a company. Rather, it is the way the market reacts to the news of the split which will cause any consequential price movements. The same is also true for share consolidations.

Therefore, it is recommended that you should use the news of any upcoming stock splits in conjunction with other information about the company. Learn about the drivers behind the company's decision, read the company's news, analyse their fundamentals and look at technical indicators to examine recent price movements.

Splits and reverse splits are normally announced weeks before they are implemented and sometimes there are rumours of them beforehand, giving a trader more time to think about what action to take.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.