Stock Split... Bad News or New Opportunity?
2019-05-28 | Simpler Trading Team
News of a stock split may invite visions of adding more stock to your portfolio or doubling your money, but there’s more to how this financial pie will be sliced.
Investors may have more pieces of the pie following a stock split, but the investment value stays the same.
A stock split announcement (especially a reverse stock split) may excite newer retail investors while seasoned stockholders will exercise caution, even concern, over the news.
When this corporate financial maneuver becomes news you’ll need to ask questions about the event. You’ll need to know how a stock split will affect your trading account. Details are important when a split happens.
You’ll want to have a plan in place depending on where you are in a trade involving a stock split.
Companies use different methods to maintain share value in the marketplace, including a stock split and a reverse stock split.
A stock is simply a purchase of a small part of a company. A stock is an investment that maintains a “share” of ownership or equity in the company. This partial ownership provides potential for profit from the success of a company while also exposing the investor to financial risks if the company fails.
A stock split can be news of continued strength for a company or a signal the company is in trouble.
Let’s take a look at a stock split definition and what these events may mean for your investment.
What is a stock split and can I make more money?
A stock split is actually a simple process publicly traded companies can enact. The key is how it will ultimately affect your investment.
When asking, “Why do stocks split?” keep in mind that companies are always working to boost their financial standing. Stock splits are one tool in their accounting arsenal.
Companies split shares when they add to the number of outstanding shares by giving more shares to investors already owning stock in the company. Here’s an illustration of how it works:
A stock split is like exchanging a $100 bill for smaller bills. You have the same amount of money it’s just divided into smaller denominations. If you have a 2-for-1 stock split, you now have two $50 bills and if you have a 10 for 1 stock split you now have 10 bills worth $10 each. The value of your asset remains the same at $100 but you now have more pieces adding up to the same value.
Likewise, when a stock splits there is no increase in the overall value of the security but you do have more “pieces” of stock. Each new stock now has a lower value but your percentage of ownership and investment value remains the same.
Options traders experience the same process when a stock splits. Any option held at the time of the stock split is concurrently divided in the same manner. Options positions are adjusted automatically according to the stock split ratio.
Following the 2:1 example above, let’s say an options trader has a call option on 100 shares of the company stock with a strike price of $100. The stock splits and the option is automatically adjusted. The trader now has two call options with a strike price of $50 each.
The value of the trader’s investment hasn’t changed, but he is now holding an extra call option.
A stock split doesn’t change the overall value of a shareholder’s (or option trader’s) investment. Likewise, the overall value of the company, i.e. market capitalization doesn’t change.
Market capitalization is determined by multiplying the current price of a stock by the total number of outstanding shares. Outstanding shares is the number of shares that are being traded publicly. So, a company with 1 million shares outstanding priced at $50 per share would have a market capitalization of $50 million.
Why do stocks split?
There are several reasons that may prompt a company to split its stock.
Stock prices for profitable companies can keep rising to the point retail investors can’t afford the expensive shares. This limits any broad investor appeal of the stock within the market. Examples today are high-tech stocks priced at $1,000 or more per share.
Average investors can’t lay out hundreds of thousands of dollars to purchase sizable numbers of expensive shares. Despite the certainty of dividend payouts and a long history of success, the price is too steep for much of the market.
Companies can use this as an opportunity to offer a stock split which then lowers the price of its shares. A stock trading at $1,000 drops to $500 per share on a 2:1 stock split and down to $100 per share on a 10:1 split. Lower share prices can offer a more affordable appeal to a broader range of potential investors.
Such a stock split would then provide more liquidity within the market. This means investors could more quickly buy and sell the lesser-priced stock. An advantage to this added liquidity is investors might see the stock as less risky. Any perception of lowered risk and price affordability works to the advantage of the company issuing stock.
Another reason for a stock split may be to stir up demand. Lower stock prices mixed with added liquidity and less perceived risk may boost perceived value as an attractive investment to more investors.
As in any market, increased demand of a stock with a fixed supply generally leads to a price increase. If a stock’s price rises due to more demand, then the overall value of the company increases.
A stock split can prove valuable for investors and the issuing company.
The question then becomes why don’t more tech companies with expensive shares split their stock?
The answers can be debated for hours, but suffice it to say there are few, if any, negative effects on companies who don’t split their high-priced stock.
Market demand keeps the stocks selling and rising in price. Electronic trading also allows smaller retail investors to buy just a few stocks without spending a huge fortune. Investors wanting to invest in three or four shares can buy that stock with the touch of a button.
Watch out for a reverse split
A reverse split means investors are about to see their number of shares be cut while the issuing company works to boost its market value.
It’s usually not a good sign for investors, or the issuing company.
Companies issue a reverse stock split in an effort to force an increase in a low or devalued stock price.
This accounting maneuver happens when the number of outstanding shares of a company are cut. As an illustration, an investor holding 1,000 shares of a company would have his holdings cut to 100 shares in a 1:10 reverse stock split. If shares were trading at $1 before the reverse split, then the individual share price would jump to $10 per share.
The investor would still be holding the same overall value in stock, or $1,000. At the same time, the company is still valued at the same market capitalization as before the reverse split.
There is a dark side of this for smaller investors. Anyone owning just a few shares could lose their stock.
As an example, if a company issues a reverse split of 1:100 any stock owners with less than 100 shares ends up with no stock holdings. These shareholders would receive cash value of the stock and lose their small ownership in the company.
There are several reasons why companies might force a reverse stock split.
Companies issuing a reverse split are banking that the sudden “jump” in share prices will increase demand for the stock. The increase in per share price might look attractive to investors who notice the sudden increase.
This is why it’s important to research why a company issues a reverse split.
A reverse split may also be a sign of desperation by a company whose stock has fallen below acceptable levels. Stocks must maintain a minimum price to remain listed on most market exchanges. If a stock price falls below the minimum, the market may delist the stock. The New York Stock Exchange can delist stocks trading for less than $1 per share. This usually happens over a period of time as the company tries to regain market price.
A company that loses its listing on an exchange has limited opportunities to raise capital or improve its market capitalization.
A reverse stock split doesn’t guarantee a new, higher stock price will hold.
Investors may see the stock price “increase” as an opportunity to sell off a struggling stock.
This can cause the price to drop again and still lead to delisting from the exchange.
It can be a vicious cycle if the company isn’t healthy and the reverse split is just a financial gimmick to raise the stock price and avoid being delisted.
Investors would be exercising appropriate caution if they dig into the health, or true value, of any company that issues a reverse split.
Stock split: Opportunity or red flag?
Companies issue stock to raise capital to expand the company through sales, debt repayment, infrastructure, or research and development. Companies then share partial ownership of the business with investors who buy stock.
Investors risk their money in hopes the company pays a good dividend (a portion of earnings) into the future or the price raises so they can sell the stock for a profit.
Splitting stock boils down to a financial strategy that ultimately benefits the company more than investors. Companies always hope a stock split - regular or reverse - boosts their stock price and their ability to improve their financial situation.
Any stock investment comes with risk.
If the company uses investor’s money successfully, share prices can rise and the company value can grow. If the company is not successful, investors can lose all their money invested in the stock.
Option traders face these same financial risks. Any significant changes in value of a company’s share price can wipe out options investments or lead to a profit rally.
Whether you invest in stocks or options, stock splits aren’t the opportunity they once were for investors.
As John Carter of Simpler Trading explains, stock splits aren’t being used by companies as they maintain high stock prices and a stock split isn’t the “buying signal” of years past.
Carter explained that the “dot com” bubble burst in 2000-2001 changed investment attitudes. Markets lost billions and internet companies were wiped out in the “dot com” crash.
Before this bubble collapse in the market, companies could use a stock split as an advantage. Companies would typically split stock and then the price would rally and rise back to the pre-split price.
“Since the bubble burst, it is basically a non event,” said Carter, an 8-figure stock and options trader. “A stock split isn’t likely to provide a stock price rally for investors like it once did.”
Always search for the true value of a stock - company health, sales numbers, earnings history, and growth plans. Compare this to the competition and the overall market. Back all this information with accurate technical analysis and you’ll be better informed about a company’s value and its stock’s potential as an investment.
There really isn’t a stock split calendar (like an earnings calendar) for upcoming stock splits. But you can check a company’s stock split history or any recent stock splits with some basic internet research.
When a company announces stock split news, it’s good to backtrack through its past stock split history to gain a better perspective of its overall financial health.
A stock split may sound like an enticing investment opportunity but caution should be the rule.
Remember to base any buying decisions with a dose of reality where recent stock splits may be nothing more than a financial maneuver to manipulate the sentiment of investors and the public.