Earlier this month, Alphabet (GOOGL), the parent company of search engine Google, announced plans for a 20-for-1 stock split. That means that for each share of Alphabet you own, you’d get 19 additional shares. This isn’t the first time that an investor darling has split its stock. Back in the second half of 2020, both Apple (AAPL) and Tesla (TSLA) announced stock splits. Apple announced a four-for-one split, while Tesla announced a five-for-one split. Alphabet itself had split its stock before – in a 2-for-1 split in 2014.

What does this mean for shareholders?

Just math

Simply put, a stock split is exactly what it sounds like. One share gets divided, or split, into multiple shares. Don’t worry, though. The value of your holdings is the same, just in smaller chunks.

Think about it like a dark chocolate bar. Your one big dark chocolate bar is broken down into multiple bite-size pieces. You still have the same amount of chocolate, just in smaller pieces.

Similarly, in a stock split, it is very important to remember that the price of the share also is reduced. For example, if a company board announces a two-for-one split, then you get one extra share for each share you own. But the share price will be halved. In this example of a two-for-one split, if you had one share of Company X at $10 per share, you now have two shares of Company X at $5 per share.

This does not mean that the stock has become cheaper. The fundamentals of the company and the stock price have not changed. Sticking with the dark chocolate bar analogy, after breaking the bark into smaller bits, you have smaller bits of dark chocolate, not more chocolate overall.

But why?

Why do companies announce stock splits?

Stock splits are a way for companies to increase the overall liquidity.

Liquidity means the ease with which investors can buy or sell shares on a stock exchange. The smaller the dollar amount of each share, the smaller number of shares are needed by even the smallest investor to buy or sell that stock.

In most cases, stock splits are undertaken by companies when the share price has gone up significantly, particularly in relation to a company’s stock-market peers. If the share price becomes more affordable for smaller investors, it can reasonably be assumed that more investors will participate, and so the overall liquidity of the stock would increase as well.

But remember this with stock splits: Though the number of outstanding shares changes, and though the price of each share changes, the overall market capitalisation of the company stays the same. The value of the company doesn't increase when a split occurs, therefore the value of your stocks, your shares, doesn't change, either.

Take Alphabet for example. It closed Tuesday, Feb 1st at $2572.88. Many investors (myself included) would not be able to invest in Alphabet, because I do not have $2500-odd to invest in one share of one company. Now if the stock split were to happen as of Tuesday's close, the cost of each share would go from $2572.88 to $128.64, and each existing holder would get 19 additional shares for every share they own. A stock price of $128-odd would be much more manageable, both for me, and for many others.

This is especially true now with more and more investors having access to low-cost trading platforms. Buying and selling stocks is now easier than ever, and for many investors, these recent splits might be an entry point for companies they have long admired.

All of this being said, these recent high-profile splits seem superfluous given that most brokerage platforms now enable trading in fractional shares. Perhaps the psychology of owning at least one whole share is at play in the companies’ decisions.

But additional participation by smaller investors could also lead to the price increasing, which we saw in the prices of both Apple and Tesla immediately after the stock split announcement.

"When we strictly observe the value of an investment immediately after a stock split, there really isn't a discernable pattern in the change in wealth. What is noticeable is the trading volume of the stock which might be attributed to news flow. All this said, for long term investors in a stock, a stock split (or reverse split) really doesn't affect the fundamental value of the company or the wealth in your pocket," points out Morningstar Canada's Director of Investment Research Ian Tam.

Does the company change?

Not at all. Stock splits do not alter the fundamentals of the company in any way, apart from the short-term price increases we described earlier. There’s no harm done in this regard if the stock doesn’t split either.

Alphabet (GOOG) (GOOGL) made this announcement while releasing its fourth-quarter 2021 results, which were driven by continuing growth in search advertising, further YouTube monetisation thanks to the strengthening of its network effect moat source, and acceleration of Google cloud growth. It was a bumper quarter for Alphabet.

"Strong revenue also created operating leverage, widening margins more than expected. While we expect slower revenue growth this year, we project double-digit growth in YouTube and cloud to continue. We have modeled lower margins in 2022 given Alphabet’s continuing aggressive investment in its cloud offerings. We foresee a return of margin expansion in 2023 due to the steady increase in Google’s cloud recurring revenue," said Morningstar analyst Ali Moghrabi. After considering the time value of money, Moghrabi increased his fair value estimate 4% to US$3,600.

The upside down

The opposite of a stock split is a reverse stock split.

In the case of reverse stock splits, the company divides the number of shares that investors own, rather than multiplying them. As a result, the price of the shares increases.

For instance, if you own 10 shares of Company X at $10 per share, and the company announces a one-for-two reverse stock split, you end up owning five shares of Company X at $20 per share. Usually, reverse stock splits are announced by companies that have low share prices and want to increase them – oftentimes to avoid being delisted.

You may think that reverse stock splits are bad news for the company, but this is not always the case. One of the most famous examples of reverse stock splits is Citigroup (C). Its share price declined to under $10 during the 2008 financial crisis and stayed there, so the board decided in 2011 Citigroup to do a reverse split of one-for-ten. The split took the price from US$ 4.50 per share to US$ 45 per share. The company—and the stock—survived and is now trading at around US$ 52 per share.

See, just math!