If you own Amazon (or any other stock over the years that suddenly carries a lower per share price), you may have the same question I heard this week – what is a stock split and why would a company choose to do this?
What is a stock split?
A stock split is a decision made by management that allows them to reduce the per-share price of their stock. The price per share is decreased by the same factor that the number of shares outstanding are increase. Stock splits are purely cosmetic and do not/should not have an impact on the underlying valuation of the stock (see more on this later).
Note: There is also an ability for a company to do a reverse stock split (ie: increase the cost per share). It’s basically this process in reverse but as splits are more common, we will just cover that here. If you are dying to know more about a reverse split, just ask the question and perhaps you’ll be featured in the next column 😉
How do stock splits work mechanically?
Companies determine the exact conversion ratio and on the date of the split, every holder will receive more shares with a lower cost per share. Let’s use Amazon as an example, as it just occurred earlier this week and is a widely known stock:
As a shareholder, this will all happen seemlessly in your eyes. Your custodian (such as Charles Schwab) will process this on your behalf and your per share price, number of shares, and cost basis will all be automatically adjusted for the split
Why would a company split their stock?
As you can see above, there is a decent amount of effort and logistics to split a stock and yet, there is no impact on the value of the stock just from the split (shares go up, per share price goes down, value stays the same). So why would a management team elect to do this? Here are some common reasons for such a transaction. We’re again using Amazon as an example – but many of these factors apply to other companies that split their stock
1.) Increase affordability – Decreasing share price used to be very important, with minimum 100-share lots set by brokers, accompanied by high trading fees. High per-share prices made buying stocks in these high lots cost prohibitive for many. Nowadays, in the era of $0 trading costs and access to fractional shares at many custodians, this isn’t as much of any issue. However, many investors prefer to hold full shares and lowering the price can make a stock more attractive – especially to retail investors who may not wish to put over $2,000 in any one name (as was the case with Amazon)
2.) More liquidity – with more shares outstanding (and more individuals able to trade in the stock), liquidity in the shares can be increased by a stock split
3.) Stock compensation – stock compensation is increasingly common. A lower share price allows employees to better manage the financial implications of exercising options, etc.. In the case of Amazon employees, they can now sell shares with 1/20th the value than before, allowing them to more exact in handling stock comp and the underlying tax implications
4.) Index inclusion – sometimes, there is speculation splits are done to allow for inclusion in a market index. Such inclusion can trigger more buying/support as investments that track the index would then need to own the shares. In Amazon’s case, the rumors are concerning the Dow Jones Industrial Average. Since that average is tied to share price (not market cap as is true for the S&P 500), Amazon’s prior share price would have given it too high of a weighting in the index. Time will tell if this comes to pass but it can be another underlying reason
Why do shares sometimes go up on the news of a split?
Rest assured, there is no impact on the stock from the split alone (shares go up, price goes down, total value stays the same). However, many stocks will rise on the news of the split. Why is that if markets are so efficient? Remember, markets are forward looking and are trying to take future events and assign them a price today. It’s likely that markets are assuming positive price action in relation to the items noted above (better liquidity, more retail demand, addition to index that sparks more demand) and adjusting today’s price upward for those future events – or the shares may simply be reacting to other news/changes that occur on the same day the split is announced.
With the success of many widely-held stocks over recent years (Apple, Tesla, and soon to include Google), splits have become increasingly common. Now you are prepared to explain them to a friend!
Note: This post is for informational and educational purposes only. It does not serve as financial advice and is not a recommendation of any stock mentioned herein.
Leave a note