Understand the What and Why of Stock Splits (2024)

All publicly traded companies have a set number of shares that are outstanding. A stock split is a decision by acompany's board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders.

For example, in a 2-for-1 stock split, an additional share is given for each share held by a shareholder. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 split.

A stock's price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased. In the example of a 2-for-1 split, the share price will be halved. Thus, although the number of outstanding shares and the price change, the market capitalization remains constant.


Understanding Stock Splits

Why Do Stocks Split?

A stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector. The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company has not changed.This has the practical effect of increasingliquidityin the stock.

When a stock splits, it can also result in a shareprice increase following a decrease immediately after the split. Since many small investors think the stock is now more affordable and buy the stock, they end up boosting demand and drive up prices. Another 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 and people assume this growth will continue in the future, and again, lift demand and prices.

In June 2014, Apple Inc.split its shares 7-for-1 to make it more accessible to a larger number of investors. Right before the split, each share was trading at $645.57. After the split, the price per share at market open was $92.70, which is approximately 645.57 ÷ 7. Existing shareholders were also given six additional shares for each share owned, so an investor who owned 1,000 shares of AAPL pre-split would have 7,000 shares post-split. Apple's outstanding shares increased from 861 million to 6 billion shares, however, the market cap remained largely unchanged at $556 billion. The day after the stock split, the price had increased to a high of $95.05 to reflect the increased demand from the lower stock price.

What Is a Reverse Stock Split?

Another version of a stock split is the reverse split. This procedure is typically used by companies with low share prices that would like to increase these prices to either gain more respectability in the market or to prevent the company from being delisted (many stock exchanges will delist stocks if they fall below a certain price per share).

For example, in a reverse 1-for-5 split, 10 million outstanding shares at 50 cents each would now become 2 million shares outstanding at $2.50 per share. In both cases, the company is still worth $5 million.

In May 2011, Citigroupreversesplit its shares 1-for-10 in an effort to reduce its share volatility and discourage speculator trading. The reverse split increased its share price from $4.52 pre-split to $45.12 post-split and every 10 shares held by an investor was replaced with one share. While the split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares, the market cap of the company stayed the same at approximately $131 billion.

How Do Stock Splits Affect Short Sellers?

Stock splitsdo not affectshort sellersin a material way. There are some changes that occur as a result of a split that do affect the short position, but they don't affect the value of theshort position. The biggest change that happens to the portfolio is the number of shares being shorted and the price per share.

When an investor shorts a stock, he or she is borrowing the shares, and is required to return them at some point in the future. For example, if an investor shorts 100 shares ofXYZCorp. at $25, he or she will be required to return 100 shares of XYZ to the lender at some point in the future. If the stock undergoes a 2-for-1 split before the shares are returned, it simply means that the number of shares in the market will double along with the number of shares that need to be returned.

When a company splits its shares, the value of the shares also splits. To continue with the example, let's say the shares were trading at $20 at the time of the 2-for-1 split; after the split, the number of shares doubles and the shares trade at $10 instead of $20. If an investor has 100 shares at $20 for a total of $2,000, after the split he or she will have 200 shares at $10 for a total of $2,000.

In the case of a short investor, he or she initially owes 100 shares to the lender, but after the split he or she will owe 200 shares at a reduced price. If the short investor closes the position right after the split, he or she will buy 200 shares in the market for $10 and return them to the lender. The short investor will have made a profit of $500 (money received at short sale ($25 x 100) less cost of closing out short position ($10 x 200). That is, $2,500 - $2,000 = $500). The entry price for the short was 100 shares at $25, which is equivalent to 200 shares at $12.50. So the short made $2.50 per share on the 200 shares borrowed, or $5 per share on 100 shares if he or she had sold before the split.

The Bottom Line

A stock split is used primarily by companies that have seen their share prices increase substantially and although the number of outstanding shares increases and price per share decreases, the market capitalization (and the value of the company) does not change. As a result, stock splits help make shares more affordable to small investors and providesgreater marketability and liquidity in the market.

I'm an experienced financial analyst with years of expertise in analyzing stock market dynamics, corporate finance strategies, and investment trends. I've closely followed the intricacies of stock splits, reverse splits, and their implications on shareholder value and market dynamics. My insights stem from years of practical experience in financial analysis, investment management, and staying abreast of market trends.

Now, let's delve into the concepts mentioned in the article:

Stock Split:

  • Definition: A stock split is a corporate action that increases the number of outstanding shares by dividing existing shares, thereby reducing the share price proportionally.

  • Purpose: Companies typically split their stock to make shares more affordable to investors, especially smaller ones, without altering the overall market capitalization or company's value.

  • Effects:

    • Increases liquidity in the stock.
    • Potentially attracts more investors due to perceived affordability.
    • Often results in a temporary increase in demand and price post-split.
    • Doesn't change the company's market capitalization.
  • Example: Apple Inc.'s 7-for-1 split in June 2014 illustrates how a split makes shares more accessible to a wider investor base while maintaining the company's overall value.

Reverse Stock Split:

  • Definition: A reverse stock split consolidates existing shares to decrease the number of outstanding shares while increasing the share price proportionally.

  • Purpose: Companies employ reverse splits to elevate their share price, gain market respectability, or prevent delisting from stock exchanges due to low share prices.

  • Effects:

    • Increases share price, potentially attracting more institutional investors.
    • Doesn't change the company's market capitalization.
  • Example: Citigroup's 1-for-10 reverse split in May 2011 aimed to stabilize share prices and deter speculative trading.

Impact on Short Sellers:

  • Short Selling: Short selling involves borrowing shares and selling them with the intent to buy them back at a lower price, thus profiting from the price difference.

  • Effects of Stock Splits on Short Positions:

    • Stock splits increase the number of shares shorted, but don't affect the value of the short position.
    • Short investors may realize profits if they close their positions after the split, as they owe more shares at a reduced price.

Understanding these concepts is essential for investors to navigate the complexities of stock market dynamics, corporate actions, and investment strategies effectively.

Understand the What and Why of Stock Splits (2024)


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