What is a stock split and what does it mean for you?
Stock splits happen from time to time, so it's important for us as investors to understand what they mean and how they might impact our investing decisions.
Consider this a crash course to stock splits. Let's begin.
Stock Splits Can be Deceiving
Say you are interested in investing in a company and you are waiting for its price to drop to your “buy price” so you can get a great return on your investment. One day, you wake up and see that the price of that company’s stock is half of what it was before. So, you pull the trigger and BUY!
Sound familiar? Well, this is NOT a smart move.
When a company decides to undergo a stock split, its stock price very well could be for sale one day at half of what it was the day before.
If you’re not paying close attention, you may not realize that it is just as expensive—if not more—than it was before the stock split and buy at the wrong price. In reality, the new lower price of a company’s stock after it undergoes a stock split has nothing to do with its true value.
What Is A Stock Split?
A stock split is when a company decides to exchange more shares of its stock at a lower price for stockholders' existing shares.
So, what happens to a stock’s price when it splits?
Nothing actually, although, it’s going to look like something big happened. Stock splits don’t change the market cap, which is the market price of the stock on a given day multiplied by all of the shares, or the sticker price of a stock one single cent. Not a penny. All a stock split does is change the number of shares and the price per share. I repeat: this does not change the total value of all those shares by even one cent.
Think of it this way: if you had a pizza originally cut up into 4 pieces, now cut up into 8 pieces, the actual value of the pizza doesn’t change.
What Happens When a Stock Splits?
Let’s say Starbucks is selling for $100.
The $100 per share price means that Starbucks is being priced by Mr. Market a total price of $100 times all the shares of Starbucks that are out there.
Starbucks has over a billion shares that are owned by investors, but for easy math, let’s call it an even billion. The market cap of Starbucks on this day would be $100 billion.
Then, Starbucks announces a stock split.
After trading finishes on the day of the announcement, the accountants at Starbucks issue two new shares of Starbucks stock to every shareholder in exchange for one of their old shares.
The business suddenly no longer has 1 billion shares. It now has 2 billion shares. Nothing magic has happened, though. All that happened is that Starbucks took those 1 billion shares and issued 2 billion shares as a replacement.
Did the value of Starbucks change? No. Did the market suddenly re-price each share of Starbucks because they now have a whole lot more stock out there? Yes.
The next trading day, the market price of Starbucks will be around $50 per share. The price gets cut in half because the value of the business didn’t change at all just because the management split the stock.
Therefore, if the business is still worth 100 billion, the price per share has to be half of what it was before the split in order to keep the total market cap the same.
A stock split doesn’t change the business at all. All that happens is that the price per share changes to adjust for the new shares that have been introduced.
Why Do Stocks Split?
So why, if splitting the stock doesn’t change the market cap or the value of the business by even one cent, does the CEO of Starbucks bother to play this little accounting game?
For one and only one reason: A lower stock price makes it easier to trade because the stock becomes more attainable for interested investors who may have been priced out of buying it in the past.
Lower prices make it easier to find buyers than higher prices.
When a stock price goes over $100 a share, people start to think of it as ‘expensive’ even though the price of the stock has nothing to do whatsoever with the actual market cap of the business.
A business worth $1 million is worth $1 million whether there is one share worth $1 million or 1000 shares worth $1000 each or 1 million shares worth $1 each.
But how many buyers are there out there for a single share of stock worth $1 million? Not very many. Let’s say there was one buyer.
The owner of that single share might have to take a much lower offer simply because there is only one buyer. But if there were a million shares at $1, there can be lots of buyers. Lower stock prices make trading easier, which makes for more trading.
More trading often makes for higher stock prices.
Types of Stock Splits
There are a few main types of stock splits a 4-1 stock split, a 2-1 stock split, and a 3-1 stock split. Once you understand one type, you’ll understand them all...
What is a 4 for 1 Stock Split?
If you own 1 share of a company before the stock split, you will own 4 shares of the company after the stock split.
What is a 2 for 1 Stock Split?
If you own 1 share of a company before the stock split, you will own 2 shares of the company after. If you own 5 shares of a company before the 2-1 split, you will own 10 shares of the company after the split.
And so on If you own one share of a company and the stock splits 3 for 1, you’ll own 3 shares of the company after the split.
What Does A Reverse Stock Split Mean
In addition to how many shares a stock splits into, a stock can also split forward and reverse.
Unlike a forward stock split, where shareholders get more shares for their money, a reverse stock split would reduce the number of shares each sha0reholder has but the value of those reduced shares would remain the same.
For example, if you owned 4 shares valued at $100 each for a total value of $400, and the stock underwent a 4-1 reverse split, you would only own 1 share of that stock, but it would still be valued at $400 total.
The problem with reverse stock splits is that they are typically executed when a company’s stock price is in danger of being delisted (under $5) or the company wants to improve its image. In either case, a reverse stock split could very likely be an indication of poor company performance.
Warren Buffett on Stock Splits
So, what does one of the greatest investors of all time have to say about stock splits? Well, Warren Buffett chooses not to split stock of his company, Berkshire Hathaway (BRK). Instead of encouraging trading, Buffett prefers his shareholders never sell a single share.
To discourage trading in BRK, Buffett has steadfastly refused to split the stock—ever. He thinks refusing to split the stock, BRK, helps keep the price close to its value.
Many other CEOs just want the highest price, not the price it's worth.
Driving the price of a company’s stock up is important to most CEOs because of misguided incentive programs, option trading pressures, and influence from fund managers who want short term success. None of these reasons for splitting stocks have a single thing to do with improving the true value of the business.
Bottom line on stock splits: They have no effect on the true value of a company. Don’t take a stock split too seriously.
As Rule #1 Investors, we care about the value of a company, not its stock price. We don’t base our investment on a company on the price per share, but instead, look at the entire company as a real owner does.
When you invest this way, you don’t have to speculate whether or not you should invest in a company based on a stock split.
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