When a stock splits and no one is around to hear it, does it make a sound? But seriously — when a stock splits, what actually happens? And perhaps more importantly, what does a stock split mean for you as a trader?
In this stock split guide, I’ll go over what it means for a stock to split, the effects of the split, and how you can benefit from stock splitting.
Table of Contents
- 1 What Is a Stock Split?
- 2 Is a Stock Split Good?
- 3 Recent Stock Split Examples
- 4 What is a Reverse Stock Split?
- 5 My Stock-Split Tips for Traders
- 6 The Bottom Line
What Is a Stock Split?
Stock Split Definition: When a stock splits, the company divides its existing shares into multiple shares. It’s also referred to as a “forward split” as opposed to a reverse split, which we’ll get into later.
Have you ever seen the movie “Fantasia”? In it, there’s an animated short called “The Sorcerer’s Apprentice” featuring an enchanted broom that Mickey Mouse chops into pieces, then the shards turn into more brooms. That’s kind of the phenomenon with stock splitting, but with more numbers and less magic.
The split occurs when a company’s board of directors decides to increase the number of outstanding shares. They do this by issuing additional shares to current shareholders.
Despite the fact that the number of shares outstanding has increased, the total dollar amount of the shares remains the same. So by simply splitting the stock, the company doesn’t gain any value.
For example, say that a company has decided to do a 3-for-1 stock split. Say that you currently hold 100 shares of their stock with a value of $200. When the stock splits, you will have 300 shares, but the total value will still be $200.
Defining Share Splits
When a stock has a forward split, the number of shares added are typically listed by a ratio. So, if the amount of shares were doubled, it would be a 2-for-1 split. Other common ratios are 3-for-1 and 5-for-1.
Why Do Stocks Split?
Why would a company bother to do a stock split if it doesn’t increase the value of their company? What happens when a stock splits?
Usually, a stock split occurs in companies that have seen their share prices skyrocket to levels that they deem too high for the average trader.
The intention of a stock split is to make the shares more accessible to smaller investors without sacrificing or changing the underlying value of the company.
For an investor trading from a small account, it’s much easier to invest in shares if they are priced at $10 each versus $200, for example.
Companies including Google and Apple have split their stock in the past. But just because a company is big doesn’t necessarily mean its stock will split.
Some companies don’t split. As I shared previously, Berkshire Hathaway A shares are known for never having a stock splits. The Berkshire A shares are currently priced around $299,380.00 per share.
Alternatively, they may notice that their shares are higher-priced than those of similar companies, and they want to stay competitive.
Is a Stock Split Good?
A stock split in and of itself is actually a neutral thing. It’s a simple method of dividing the shares. However, it can be an indicator of good things to come for both the company and its investors.
The idea is that if a company’s stock price is elevated to the point where a split is required, it’s a good indication that they have potential to rise even further and that it’s a good idea to buy.
However, just because a stock has a forward split doesn’t instantly make it a great investment. There’s plenty more research that must be done to make that determination.
Advantages of Stock Splits
How could a stock split be beneficial? Let’s delve into some of the potential effects of a stock split and why it can be considered an indicator of good things to come.
Liquidity can help a stock move, since more shares are available to buy or sell. But it’s a delicate balance.
Having too few shares can be dangerous, because the price can move so fast that just a few shares in a transaction can kill a run.
Yet having too many shares can be a problem too, because it will make it so that a stock will never change in price more than a few pennies at a time.
Overall, higher liquidity is seen as a good thing. Since most favor long stocks, the idea of a slow uptrend will be noticed in time. However, on the flip side, a little-noticed stock can see their share price erode post-split.
For example, if a stock is trading at $600 per share, it will shut out a lot of buyers. If you had $6,000, you would only be able to buy 10 shares! That doesn’t offer you much flexibility or much of a chance to diversify.
Because of this, few buyers with smaller accounts will go for an opportunity like that.
However, if the stock splits and the per-share price is reduced, you have the opportunity to purchase more shares and take a larger position.
So from a company’s point of view, this can be a tactical method of attracting more investors and being exposed to a greater audience.
Recent Stock Split Examples
Here are a couple of profiles of recent stock splits. They both offer good examples of when a split is a good sign of future growth in a company.
Insurance company AFLAC, with its infamous duck mascot, has been quacking all the way to the bank. The company, which provides insurance to workers in the United States and Japan, has created a successful business model.
Their success has shown in their share price, which has risen substantially in recent years. In March of this year, AFLAC announced a 2-for-1 stock split, citing the goal of improving the stock’s liquidity.
This was AFLAC’s ninth stock split, and was delivered as a 100 percent stock dividend.
With a recent company restructure and tax reforms acting in the company’s favor, AFLAC has been on the receiving end of positive press as of late.
With all this attention and a new, shiny low price for their stock, AFLAC is well poised to benefit from this split. For buyers, it seems like a very positive sign.
Intel who? Not long ago, Samsung exceeded Intel as the world’s biggest supplier of semiconductors, with over $69 billion in revenue in 2017.
Before the stock split, Samsung’s stock was over $2,300 per share. Prior to the split, only a very small percentage of shareholders were individuals.
Following the split, it was only about $45 per share, which made it much more affordable to individuals.
This is a great example of a company leveraging good news to promote the stock split and gain more investors.
To Split or Not to Split: the Amazon Example
To consider the effects and implications of a stock split, let’s consider the curious case of Amazon.
Amazon is a great example of how a company might choose to split or not to split. This is because they show both sides of a stock split: the benefits and the downfalls.
Amazon was founded in 1994. In 1998 the stock split for the first time, with a 2 for 1 stock split. Then in January 1999, it had a 3 for 1 stock split. Later in 1999, it had a third split, with a 2 for 1 split.
If you’re not inclined to whip out your calculator, here’s the breakdown: If you bought 10 shares in 1997 or so, you’d have owned 120 shares within just a few years’ time.
When Amazon did these splits, the motivation was to allow individual or smaller investors to buy shares at more affordable rates. Otherwise, the share prices easily could have gone into the triple digits, which would have shut out many investors.
But it wasn’t all positive growth after the splits. After the 1999 split, Amazon had a huge decline.
Owing partially to the splits it made, the shares fell extremely low, into the single digits. For many investors, this is a strong indicator that a stock is on the decline and should be avoided.
Returning to fortune took time. The investors who initially bought when Amazon was at its triple-digit levels had to hold on for a long time to see a return. It wasn’t until the late 2000s that Amazon’s stock price returned to that level and began to creep even higher.
Investors began talking about a split, but it didn’t happen.
In recent years, Amazon has made huge strides, including their acquisition of Whole Foods, the continued development of Amazon Prime, and many other offerings and services. At the time of this writing, the price of a single share of Amazon stock is about $1,829.
The split still hasn’t happened. If you Google it, the internet is rife with theories on if and when it will happen.
Founder Jeff Bezos is understandably not quick to split the stock again after his past experience. However, it’s been a long time, and the current price is high.
In a recent interview, Bezos said that while the company doesn’t have specific plans to split the stock anytime soon, it’s still being considered.
What is a Reverse Stock Split?
Another variation of the stock split is the reverse split. As opposed to the forward stock split, the reverse split is usually performed by companies that have a low share price.
The reverse split will have the opposite effect of the forward split, and will increase the share price while simultaneously reducing the amount of shares.
For example, say that a company does a 3-for-1 reverse split. If they have 3 million shares outstanding at 50 cents per share, the split would change the field so that they have 1 million shares outstanding at $1.50 per share.
Like a forward split, the reverse split doesn’t change the value of the company. The total dollar amount of the shares remains the same. So by reverse splitting the stock, the company doesn’t lose any value.
Defining Share Splits
Usually, reverse splits have higher ratios than forward splits. They’re listed as ratios that reveal how many shares have been reduced, like 1-for-10, 1-for-50, and so on.
Reverse splits are usually bad news. Frequently, they’re done by companies that are doing very poorly and in danger of being delisted.
One of the most common reasons for a company to be delisted? They don’t meet the minimum price requirements. So by performing a reverse split, they’re trying to remain above the minimum price needed to remain listed.
However, this isn’t always the case. They might just be trying to gain more cachet in the market by raising their price. The thinking here is that if the price is too low, people might wonder what’s wrong with the stock.
Adding to that, sometimes companies want to raise the price so that they can make the jump from a penny stock on the OTC (over the counter) to a stock listed on one of the bigger exchanges. By doing this, they may gain a larger audience and more investors.
My Stock-Split Tips for Traders
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How Do Stock Splits Affect Short Sellers?
With short selling, you’re basically betting against the stock, hoping to take profits when it declines in value. It’s not always simple, though: You have to borrow shares through your brokerage account, which means you have to find shares to borrow.
As you know from my “No Borrow, No Cry” video, they aren’t always available. You then sell the stock on the secondary market, in hopes that you’ll be able to purchase the same amount of shares at a lower price before you have to pay up on your loan.
To some, it might seem like a stock split is the best thing ever for a short seller. After all, if you just sold a bunch of shares of a stock for $10 each, then the stock had a 2-for-1 split, you could just buy them all back for half the price, right?
Sorry, but that’s not the way it works. Your order will automatically be adjusted. That means that you’d be responsible for the same dollar amount, which means double the shares. Womp womp.
Bottom line: A stock split won’t offer an active advantage to a short selling position.
Take Care with Promoters on Stock Splits
Think for yourself. This should be your mantra as a trader.
Yes, you can and should gain plenty of knowledge and advice from others. You should learn and study everything you can from my Trading Challenge lessons. You should follow the careers of other traders. And you should follow alerts.
But don’t ever simply trust one source, especially self-serving stock promoters. Never put all your eggs in one basket.
However, schemes like this aren’t isolated to just penny stocks. There are promoters who actively want to take advantage of you with stock splits, too.
A ploy that you must be wary of when trading stocks that have split is called the ‘dump and dilute.’
What happens in a dump-and-dilute scheme is that a company issues a large amount of shares on the market without a particular catalyst. This dramatically lowers the value of the share prices, and means that they’ll pretty much become worthless to shareholders.
Then, when the float has increased to a level that can’t be maintained, the company will perform a reverse split. From there, the cycle keeps going.
Promoters will promise the world with companies that are poised to split or reverse split. Always do your own research to determine whether the stock is poised to perform in a way that will be advantageous to you.
Never just trust someone else’s word!
How to Benefit from Stock Splits
I’m a big believer in the idea that there are opportunities for traders in just about every style of trading.
Like any other facet or sector of trading, stock splits can be beneficial to traders. But it takes time and plenty of hard work and study to learn how to understand and identify how stock splits could contribute to your bottom line.
Both stock splits and reverse splits are not in and of themselves profitable, but they can both act as indicators. This means that as a trader, you can consider a stock split and its effects in your stock research.
Forward stock splits can offer a powerful indicator that a stock is following an upward trend, and that you can take advantage of it.
Reverse splits may have a negative connotation, but they can also provide an opportunity. If, by raising the share price, a stock can now be listed on a bigger exchange, it may capture the eyes and interest of more shareholders. This can increase its value.
Knowledge is power. To better understand stock splits, it’s important to understand trading.
In my Trading Challenge, I offer a real-world education on trading from the ground up. My students receive support via weekly webinars and tutorials, and I consistently keep in contact as their mentor and fellow trader.
I don’t want to simply offer up some generic lessons and call it good. I want you to learn how to think for yourself and develop your own trading style. The support you receive through the many resources I offer helps make this possible.
The Bottom Line
Stock splits, whether forward or reverse, can be harbingers of opportunity for traders.
Both can act as indicators of what the future may hold for a stock — or at the very least, they can alert you to trends that are well worth tracking.
By understanding the implications of stock splits, you’ll be better poised to take advantage of them.
Have you ever had a trading experience with stock splits? Share it in the comments!