Stocks Splits: What are they and why should investors care?

Guest authored by Robert Francis, Australian Managing Director of investing platform eToro.

Two of the globe’s biggest tech powerhouses, Apple (AAPL) and Tesla (TSLA) made headlines recently when they undertook a stock split in August.

Apple split its stock on a 4-for-1 basis and Tesla split its stock 5-for-1.

But what does this actually mean?

The name itself seems pretty self-explanatory, however, for a new investor, it can be much more complex than it looks.

What are stock splits?

A stock split is when a company lowers the price of its stock by splitting each existing share into more than one share.

As the new price of the shares correlates to the new number of shares, the value of shareholders’ stock doesn’t change and neither does the company’s market capitalisation.

How do stock splits work?

Stock splitting takes the number of existing shares and divides them up at a predetermined ratio.

In other words, each individual share is worth less but investors have more shares. When combined these equate to the same value as before the split. This option leaves the underlying value of the stock and the company unchanged.

Why do companies engage in stock splits?

Companies carry out a stock split to lower their share price.

A lower share price can make the stock more attractive to a broader range of investors, many of whom could not afford the stock’s original price, so a split effectively boosts demand for the stock and drives up prices.

For example, Tesla is now trading around US$440 but before the split its shares had rocketed to over US$2200.

Post-split price increases can also occur because a stock split provides a signal to the market that the company’s share price has been increasing, which means that people may assume this growth will continue in the future. This further lifts demand and prices.

Popular types of stock splits

There are many different types of stock splits, but the most popular options are:

2-for-1: A shareholder receives two shares after the split for every share they owned prior to the split.
3-for-1: A shareholder receives three shares for every share they owned prior to the split.

3-for-2: A shareholder receives three shares for every two shares they owned prior to the split.

What’s a reverse stock split?

A reverse stock split, or stock consolidation, is the opposite of a stock split and is when you get fewer shares than you previously had at a higher per-share price.

A company typically executes a reverse stock split when its share price is in danger of going so low that the stock will be delisted, meaning it would no longer be able to trade on an exchange.

For example, Citigroup reverse split its shares 1-for-10 in May 2011, in an effort to reduce its share volatility and discourage speculator investing. With the reverse split, every 10 shares held by an investor were replaced with one share. While the split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares, the market capitalisation of the company stayed the same.

How do stock splits benefit investors?

It offers long term success: When investing in a stock split, your portfolio could see a substantial benefit if the stock continues to appreciate.

At eToro, we analysed 60 years’ worth of data and found that, on average, brands saw their share prices rocket by more than 33 per cent in the 12 months after a split. As part of the analysis, we focused on the share price movements of the 10 biggest global brands that have carried out a share split. They are Apple, Alphabet (Google), Microsoft, Amazon, Coca-Cola, Disney, Samsung, McDonald’s, Toyota and Intel.

Apple has split its shares four times in its history, with the value of those shares typically rising by 10.4 per cent in the year following the split. However, that is an average figure. Apple’s shares rose 36.4 per cent and 58.2 per cent, respectively, in the 12 months after its June 2014 and February 2005 share splits. It also saw its shares plunge 61 per cent in the 12 months after its June 2000 share split, although this was during the dot-com crash.

It improves liquidity: If a stock’s price rises into the hundreds or thousands of dollars per share, it tends to reduce the stock’s investing volume. Increasing the number of outstanding shares at a lower per-share price adds liquidity. This increased liquidity tends to narrow the spread between the bid and ask prices, enabling investors to get better prices when they invest.

It simplifies portfolio rebalancing: When share prices are lower, investors find it much easier to sell shares in order to buy new ones. Each investment involves a smaller percentage of the portfolio, which means it’s much less complex to rebalance.

Not sure how to rebalance? Simply look at your current portfolio, assess which companies you need to increase or decrease your holdings in, and identify any gaps that could be filled with a high-potential stock, commodity or cryptoasset.