You may have been hearing a lot about stock splits lately and wondering what they are and how they affect you as an investor. In this article, we’ll discuss these questions and the following:
- Define what a stock split is and why companies do them
- Look at how the split affects you as an investor
- Give our opinion on whether or not you should take advantage of a stock split
First Off, What Is a Stock Split?
A stock split is when a company divides its existing shares into multiple new shares.
For example, if you own one share of XYZ company and it splits two-for-one, you would then own two shares. A stock split doesn’t change the overall value of your investment, but it does increase the number of shares you own.
When a company does a stock split, the price per share decreases but the number of outstanding shares increases. For example, Company XYZ is trading at $100 per share and has 100 outstanding shares.
If they do a two-for-one stock split, each shareholder will end up with twice as many shares, dropping the price to $50 per share. The total shares outstanding will then be 200. If you do not sell shares, you will still own the same amount of equity in the company.
Why Do Companies Do Stock Splits?
There are a few reasons why companies might do stock splits.
The first reason is that it can make the stock more affordable for small investors. When a company’s stock price gets too high, it becomes less accessible to investors with smaller budgets. Splitting the stock decreases the price per share, making it more affordable.
Another reason companies do stock splits is to increase liquidity. Each share is worth less when more shares are outstanding, so they trade more frequently.
This increased liquidity can attract new investors and make it easier for current shareholders to buy and sell shares.
Finally, stock splits can signal that a company’s management is confident about the future of the business. When a company announces its stock is splitting, it can be a vote of confidence by management, encouraging more people to invest.
A stock split is usually accompanied by an increase in the company’s share price.
How Does a Stock Split Affect You?
If you are a shareowner and receive notification that your company is doing a stock split, don’t panic.
Whether it’s a two-for-one stock split or a three-for-two stock split, the main thing you need to know is that the value of your investment hasn’t changed. Only the number of shares you own has increased.
Take the current market price of your shares and divide that amount by the number of new shares you will receive.
For example, if you own 100 shares of stock trading at $80 per share and the company does a two-for-one stock split, you will end up with 200 shares valued at $40 each.
The reverse is also true. If a company does a reverse stock split (also called a “reverse split”), the number of shares you own will be reduced. However, the market price per share will increase in proportion to the reduction in shares.
A reverse split can be done on any ratio but is typically either a one-for-two or one-for-three reverse split.
In this scenario, each share you own will be worth more, but you will end up owning fewer shares. Let’s say you own 100 shares of stock trading at $40 per share, and if the company does a one-for-two reverse split, you will end up with 50 shares valued at $80 each.
Another term for the stock split is “equity dilution.”
This is because each shareholder’s ownership stake in the company is diluted when the number of outstanding shares increases. This dilution can affect the voting power of shareholders and the company’s earnings per share (EPS).
However, it’s important to remember that a stock split doesn’t necessarily mean that a company is doing well. In some cases, a company might do a reverse split to boost its stock price and avoid being delisted from a stock exchange. There are multiple factors to consider when determining if a stock split is a good thing.
You can use stock splits as a tax-saving strategy. When a company’s stock price gets too high, shareholders who want to sell may have to pay a higher capital gains tax.
By doing a stock split, the shareholders can sell more shares for a lower price and pay less in taxes.
Another way that stock splits can affect investors is through trading psychology, which can lead to bad decision-making.
For example, some investors might see a stock split as an opportunity to buy more shares, regardless of the company’s financial health. This could lead to them buying more shares than they can afford or investing in a company that isn’t doing well.
Even if you do not buy or sell, other investors may drive up the price of buying. This can cause the company to become overvalued, which may give you the wrong idea about the company’s true worth.
If you are a long-term investor, you should not worry too much about stock splits. But if you are a short-term investor or trader, it is important to know how stock splits can affect share prices.
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Should You Take Advantage of a Stock Split?
Some popular stocks, such as Amazon and Tesla, have done stock splits in recent years. Both company’s share prices increased significantly afterward.
If you had invested in these companies before their stock splits, you would have seen a nice return on your investment.
Stock splits can allow you to begin buying shares as the price is cut in half. For example, if a share of XYZ company is worth $1000, that may be too expensive for you. But if the company does a two-for-one stock split, the per-share price will be $500 and suddenly become more affordable.
Remember that just because something is cheaper does not mean the company’s future outlook has changed. A stock split does not increase or decrease the value of a company, it simply makes the shares more affordable.
This can be a trap for some investors who think a company’s share is on sale because its stock price has been cut in half. You are not receiving more equity, and the company’s value can potentially decline. The $500 share you bought could fall to $250 or even lower.
On the other hand, taking advantage of a stock split could allow a window of opportunity to buy normally high-priced shares at a lower cost.
If you believe in the company’s long-term prospects, this could be a good time to buy. The price may rise, causing a struggle to save enough money to buy the shares later.
However, just because a company does a stock split doesn’t mean you should automatically buy its shares. You should always research a company before investing; a stock split shouldn’t be the only factor you consider. The worst-case scenario would be if you bought shares of a company just before it filed for bankruptcy.
It is also worth noting that some companies do stock splits multiple times. There could be more opportunities to buy shares, but it could be an overvaluation of the company’s share price.
In short, stock splits can be a good thing or a bad thing. Before investing in a company that announced a stock split, research the company to sure it is a good investment.
When making investment decisions, remember the fundamentals of the company and its long-term prospects. A stock split is simply a way to make shares more affordable. It should not be the only factor you consider when making an investment decision.
Some important factors include the company’s financial stability, competitive advantages, and future prospects.
There is no right or wrong answer when asking, “Should I invest in a company that recently went through a stock split?” The answer depends on the individual company and your investment goals.
Disclaimer:
We hope the information in this article provides valuable insights to every reader but we, the Biesingers, are not financial advisors. When making your personal finance decisions, research multiple sources and/or receive advice from a licensed professional. As always, we wish you the best in your pursuit of financial independence!
