What is a stock split and how does it work?
Hi, I’m Viram from Vested and today we are talking about an interesting tool called Stock Splits
that companies use to manage their stock prices!
In this video, we will discuss how stock splits and reverse stock splits work, how they are executed, and what are the reasons why companies use stock splits as tools. We will also briefly discuss how Apple and Tesla used stock splits to manage stock prices. And finally, we will cover how YOU as an investor are impacted by these stock splits!
What is stock split?
So firstly, what exactly is a stock split?
All publicly traded companies have a set number of shares that are being traded in the market. When a company is concerned that it’s share price is too high or too low, it can opt for stock splits to manage the prices.
There are two tools a company uses to manage the share prices:
The first is a Normal stock split and the second is a Reverse stock split.
A stock split can help a company lower its share price to appeal to new investors, while a reverse stock split can actually boost the company’s share price and help preserve its listing on a major stock exchange.
Interesting right? So now, let’s see how both of these tools work.
Normal Stock Splits
First, let’s look at Normal stock splits.
In order to make the company’s shares seem more affordable to small investors, the company would do two things which is part of the stock splits.
First, it decides to increase the number of shares that are outstanding by issuing more shares to current shareholders. But, this would affect valuation right? That brings us to the second thing that the company does is that as the number of shares is increased, naturally the prices are manually reduced at the same time. This means the company’s valuation and market capitalization remain unchanged while the number of shares increase and the prices decrease.
How are stock splits executed?
Stock splits are executed in ratios. So a 2-for-1 stock split, for example, grants you two shares for every one share of the company you own.
Say you have one share of a company’s stock. If the company opts for a 2-for-1 stock split, the company would grant you an additional share, but each share would be valued at half of the original. After the split, your two shares would be worth the same as one share you owned starting with.
What is a Reverse stock split?
Now, let’s look at the other tool that the companies have which is Reverse stock splits.
A reverse stock split reduces a company’s number of shares outstanding. So, if you owned 10 shares of a stock in a company, for example, and the board announced a 2-for-1 reverse stock split, you’d end up with five shares of stock.
The total value of your shares still remains the same. If the 10 shares were valued at $4 per share before the reverse split, the five shares would be valued at $8 per share after the reverse split. In either case, the total value of your investment remains $40. But now you just own lesser number of shares vs earlier.
Why Do Companies Engage in Stock Splits?
Now why do companies engage in stock splits at all right?
So, reason number one is to increase or decrease the liquidity of the stock
When a company’s share price increases to levels that are too high, or are beyond levels of similar companies in their sector, they may decide to do a stock split. The reason for this is that a split can make shares seem more affordable to smaller investors. And this has the practical effect of increasing liquidity in that particular stock.
On the other hand, when the price of a stock drops too far, the company may lose its place on a stock exchange. How does this happen? Well, The New York Stock Exchange for example has regulatory limits for the prices of stocks. The minimum price of a stock should be $1. And if the listed stock closes the trading day beyond $1 for 30 consecutive days, it is a candidate for delisting or removal from NYSE!
To avoid this, the company uses a reverse stock split to consolidate shares in a way that results in a higher per-share price that can keep the company can still remain listed on the exchange.
Another reason a company might opt for a stock splits is to try and increase the stock price of the company.
When a stock undergoes a split, there is an immediate decrease in the stock price. But there actually could be an increase later, primarily because small investors may perceive the stock a lot more affordable and go and buy into the stock more and more.
This effectively boosts demand for the stock and drives up prices. Another possible reason for the price increase is that a stock split provides a signal to the market that the company’s share price has been increasing; people may assume this growth will continue in the future and this further lifts demand and prices for the company.
Tesla Case Study
So, this happened actually in Tesla’s case. In August 2020, Tesla announced a 5 for 1 stock split. Just after the split, Tesla’s shares were priced at about $418 per share. 4 months after its split, they fetched more than $625 per share, almost a 50% increase. As of this video’s recording, Tesla’s stocks have touched $780!
Apple Case Study
Next, let’s also look at another large company’s case study which is Apple.
In June 2014, Apple split its shares seven-for-one in order to make its shares more accessible to a larger number of investors. Right before the split, each share’s opening price was approximately $649.88. After the split, the price per share at market open was $92.70.
Existing shareholders were also given six additional shares for each share they owned prior to the stock split. So, an investor who owned 1,000 shares of Apple before the stock split now had 7,000 shares after the stock split. Apple’s outstanding shares increased from 861 million to about 6 billion shares.
However, as we discussed earlier the market capitalization of the company remained largely unchanged immediately after the split. It was close to $556 billion. The day after a stock split though, the price increased to a high of $95.05 reflecting the increased demand because of the lower stock price.
How stock splits affect you as an investor?
So, lastly let’s look at how stock splits affect you as an investor?
If you already hold a company’s shares, it wouldn’t really affect you because the underlying value of your investment is still the same. But if you aren’t a shareholder currently, a stock split could motivate you to buy. As discussed earlier, the ability for more people to buy a stock can bump up the share price of a company, which in turn might actually increase a market cap. And also, the share price becomes much more affordable right?
Alright! So, that’s it for today. What we learned was: how stock splits work?, what are stock splits?, what are reverse stock splits?, how apple and tesla use them to manage their stock prices.
Let us know in the comments if you have come across any other companies who have utilised a stock split to manage their stock prices and if there are any other interesting case studies for us.