BLOG POST: Why Do Stocks Split?

Why Do Stocks Split?

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Every once in a while, usually during bull markets, when a stock is rising, you’ll hear about a stock split. Usually splitting one share into two shares of exactly half the value, a split may seem like a pointless action. It does have some interesting effects though, even if it’s mostly psychological.

There is a conception in the markets, largely extended off of the real behavior of small-cap and penny stocks, that a smaller share price means both a more accessible stock, and a stock more likely to make big moves, while a high price per share signifies stability. Therefore, trading volume can be increased using a stock split. Increased volume can also have the side effect of giving a stock quote more visibility on TV tickers and lists of most-traded stocks.

Another reason is to increase liquidity of shares. Considering an investment like, in an extreme case, Berkshire Hathaway, trading even one whole share is a major undertaking, and many brokers don’t deal in fractional shares. While most stocks aren’t valued in the six figured like BRK.A (which has been trading above a quarter million for the last few months), even for a stock like Google that is looking at shares being worth a thousand, it’s possible that significantly more shares would be bought at a lower price. For example, someone looking to invest $2500 in shares of Google could only buy two, leaving $520 in cash, at current prices. If Google were to split 7-to-1 like Apple had done at a similar valuation, it would then be possible to buy 17 shares, with just $110 leftover, leading to 20% more funds actually invested in Google stock.

From a corporation’s point of view, another reason is to generate additional votes, especially in a corporate governance where each share holds one vote, and there are multiple classes of shares. In this case, the effect on the investor may be minimal, but it can be used to strengthen or weaken the role of corporate insiders holding preferred shares.

Finally, there is also the possibility of a reverse split. This one is somewhat more alarming, as large numbers of very low value shares are consolidated into a smaller number of relatively more valuable shares.  There is often a pressing reason to do this: NYSE and NASDAQ have minimum share price regulations to remain listed on their exchanges, rather than becoming an over the counter stock. So after a particularly bad period, some stocks will go through a more drastic reverse split of 1-for-10 or even 1-for-100 to boost a badly faltering share price and try to gain relevancy again as a smaller corporation.

Most of the time, neither type of split will have any lasting effect on valuation. There is a reputation, though it actually only happens barely more than half the time, that a stock undergoing a split will rise. Counterintuitively, there is just as much of a thought that a reverse split would boost share prices – which also happens only about half the time.

While splits and reverse splits are useful for corporate governance, investment strategies based on them are not particularly reliable or important. As an investor, stock splits are something to be aware of, but mostly just to avoid the look of shock when you see the ticker one day and your stock appears to only be worth half what it was yesterday!

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