What is a stock split and what are the causes?

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New York Yankees legend Yogi Berra once said, “You better cut my pizza into four slices because I’m not hungry enough to eat six.”

But pizza is always worth the same no matter how many slices you cut it into.

This is basically what a stock split is. A share split allows a company to divide each existing share into several new shares without affecting its market capitalization (total value of all its shares) or the participation of each investor in the company. A stock split can be a good sign for current and potential shareholders.

But most investors will never have to face or even become aware of a stock split.

“If you own 1% of the company before the split, you will own 1% of it after the split,” says Robert Johnson, professor of finance at Heider College of Business at Creighton University. “Investors tend to like splits because it indicates they are invested in a successful business. “

Keep reading to learn how stock splits work, how it affects you as a shareholder, and whether it’s worth investing in a business after a stock split.

What is a stock split?

A stock split is a corporate action taken to increase the number of shares outstanding and decrease the value of each share. In other words, as a company’s stock price rises, investors are rewarded with higher returns. But eventually, the stock can reach a price that makes it difficult for new investors to enter, that is, when the stock split occurs.

When a company performs a stock split, it uses a particular ratio to indicate how many new shares each outstanding share will be divided into. Investors will receive a number of shares equal to their current stake in the company, but reflecting the stock split.

“A stock split is when a company that issues shares wants to change the price per share,” said Meghan Railey, certified financial planner and chief financial officer and co-founder of Optas Capital. “There is no change in the market capitalization of the company. For example, if it’s a 2-1 split and the share is $ 10, you go from one share at $ 10 to two shares at $ 5 each. There is no change in economic value.

A recent example of a stock split occurred in August 2020 when Apple performed a 4-to-1 split, meaning every share in the company was split into four new shares. Shares fell from $ 499.23 per share to just $ 124.81.

Why companies are doing stock splits

A stock split is often a sign that a business is booming and its stock price has risen. While this is a good thing, it also means that the stock has become less affordable for investors. As a result, companies can perform a stock split to make the stock more affordable and attractive to individual investors.

“When a stock starts to go up and looks expensive, it was common to do a stock split to make your stock more attractive from a price per share to encourage buying the stock,” Railey said. .

And while stock splits can increase a stock’s liquidity and make it more accessible to investors, not all companies are committed. According to Railey, some companies prefer to keep their stock prices high.

“There are two types of businesses,” Railey said. “Growth companies want their stock prices to skyrocket. Tesla is happy that its price per share is high, as it adds to the appeal of its stock. Value stocks still have the option of using stock splits to attract investors. “

In perhaps the most famous example of a company avoiding a stock split, Warren Buffet’s firm, Berkshire Hathaway, never split its Class A shares. As of December 2021, the stock was trading. at approximately $ 420,000

What happens when a stock you own splits?

As a shareholder, you may be concerned that a stock split will affect your investment. But at the end of the day, there is little impact on you as an investor.

“It’s important to remember that the owner is in exactly the same position as before – their percentage of ownership is the same,” says Johnson. “They will own more shares, but each share will represent a proportionately smaller percentage of ownership in the company.”

If anything, investors may actually notice a boost after a stock split. As the stock becomes more affordable and more people can trade it, the price of the stock may increase.

What does this mean for the average investor?

Typically, stock splits are neither good nor bad, especially over the long term. When a stock splits, investors usually see an increase in interest in that stock, but things should calm down in a few days after the turmoil is over.

But if you are still worried about a stock split, consider investing the majority of your investment portfolio in an index fund or ETF that is a collection of hundreds of stocks, rather than just one. Experts agree that this is a better way to diversify your portfolio and save for retirement. Investing your money in many different companies is better in the long run than just investing in a few. Investing in this way is usually the winner over stock picking.

What is a Reverse Stock Split?

The opposite of a stock split is a reverse stock split. This is when a company reduces the number of shares outstanding. Rather than splitting each stock into multiple new stocks, a reverse stock split occurs when a company condenses multiple stocks into a single stock, which trades at a higher price.

“Just as stock splits are a sign that a business is thriving, stock splits are an admission of a struggling company – a huge red flag,” Johnson said. “Investors are well served to sell their holdings in companies announcing share consolidation. Investors who do not own securities of these companies should refrain from purchasing them. “

Just like with a stock split, there is no change in the market capitalization of a company, nor in the participation of each investor. However, they can still be a sign of trouble.

Companies can carry out stock splits to avoid being delisted from a stock exchange if they approach the minimum share price allowed on that stock exchange. They may also undertake a reverse stock split to improve the company’s public image or attract the attention of leading investors or analysts.

Are stock splits announced before they happen?

If a company in which you are a shareholder is subject to a stock split, you will be given notice. Once a company’s board of directors approves a stock split, the company is required to notify the Securities and Exchange Commission at least 10 days before the proposed split. The company usually makes a formal public announcement to alert its shareholders.

“When a company announces a stock split, it gives two dates that are important to shareholders: a registration date and a departure date,” Johnson said. “You must own the shares at the close of business on the registration date to be eligible for the split, while the actual split and adjustment of the number of shares in your account takes place on the ex-dividend date. “

Should You Invest After A Stock Split?

If you are planning to invest in a particular company after a stock split may be a good time to do so. Stock splits are usually a sign that a business is doing well, which means it could be a good investment. Also, since the price per share is lower, they are more affordable and you can potentially buy more shares.

Pro tip

If you are planning to invest in a particular company after a stock split may be a good time to do so. But remember, the key to building wealth is diversification, so individual stocks may not be the answer.

But remember that diversifying your portfolio is the key to building wealth, so consider large-scale investments like index funds and ETFs first before choosing individual stocks. The S&P 500 Index Fund is a great place to start.

Also, remember that if you invest in a business after a stock split, approach it with the same level of analysis and curiosity as any other business. While a stock split can be a good sign, it’s important to do your research before investing in a business.

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