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Investing basics: what is a stock split?

Ruth Saldanha  |  28 Aug 2020Text size  Decrease  Increase  |  
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Two US mega-caps, whose valuations have skyrocketed this year, have announced moves to make their pricy shares more accessible to investors. Electric car maker Tesla (TSLA) will split its stock 5-for-1, while tech giant Apple (AAPL) will split its stocks 4-for-1.

Tesla's shares have risen over 400 per cent this year and now trade at US$2,000 per share. Apple shares have similarly reached dizzy heights, up almost 70 per cent this year to over US$500 per share. Last week Apple became the first listed company to reach a valuation of US$2 trillion (AU$2.75 trillion), doubling its valuation in just two years.

TSLA Price Chart, 10-Yr

tesla price chart

Source: Morningstar Premium, frequency: monthly

What is a stock split and how does it benefit retail investors?

We explain.

Just math

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A stock split is exactly what it sounds like. One share gets divided, or split, into multiple shares. But don't fret - the value of your holdings is the same, just in smaller chunks. Think about it like a chocolate bar. Your one big chocolate bar is broken down into multiple bite-size pieces. You still have the same amount of chocolate, just in smaller segments.

In a stock split, the price of the share also is reduced. For example, if a company board announces a 2-for-1 split, then you get one extra share for each share you own - but the share price will be halved. In this example of a 2-for-1 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 bar into smaller bits, you have smaller bits of dark chocolate, not more chocolate overall.

Is this new?

For Apple, not really.

This will be the fifth time the stock is splitting. The company announces its first stock split in 1987; that was a 2-for-1 split. Then 2-for-1 splits in 2000 and 2005. The last stock split was a whopping 7-for-1 split in June 2014.

AAPL Price Chart with Splits

apple stock chart

Source: Morningstar Premium, frequency: monthly

For Tesla, yes, this is the first time the company has split its stock.

But why?

Why do companies announce stock splits?

Stock splits are a way for companies to increase their 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 company's overall market capitalisation 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 Tesla for example. Before the stock split, Tesla shares traded at around US$1,500 per share. Many people might not have been able to invest in Tesla because they did not have US$1,500 to invest in one share in the company. After the 5-for-1 split, the stock price will drop to around US$300 per share, which is a lot more manageable for many more investors.
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 into companies they have long admired.

All this being said, these recent high-profile splits seem superfluous given that brokerage platforms like Stake, Interactive Brokers and eToro now enable trading in fractional shares for US stocks. Perhaps the psychology of owning at least one whole share is at play in the companies’ decisions.

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 look at a company like Apple and strictly observe the value of an investment immediately after a stock split, there really isn’t a discernible pattern in the change in wealth," Morningstar Canada’s director of investment research Ian Tam says.

"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."
Here’s what happened to Apple after each of its splits:

stock split apple

Source: Morningstar Direct, data as at 10 August 2020

Does the company change?

No. 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.

Tesla and Apple were not even the highest-priced stocks in the market. That distinction goes to Berkshire Hathaway (BRK.A), which is trading at around a whopping US$318,000 per share. Another stock with a high price is the Swiss maker of Lindt chocolate, Chocoladefabriken Lindt & Spruengli, which trades at over CHF 7,500 (AU$ 11,350) per share on the London Stock Exchange.

Among the FAANG stocks, of which Apple is a part, Amazon (AMZN) is the highest priced, at US$3,200. The others are Alphabet (GOOG) at US$1,500 per share; Netflix (NFLX) at US$480 per share; and the lowest priced is Facebook (FB) at US$260 per share.

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 1-for-2 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 US$10 during the 2008 global financial crisis and stayed there, so in 2011 the Citigroup board decided to do a reverse split of 1-for-10. 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.

Recently, with the collapse of oil prices, we saw the large United States Oil Fund (USO) do an 8-to-1 reverse split when it fell to around US$2 per share. Holders of eight shares before the split would have been looking for their one share to be US$16 on the other end. They’re now around US$30 each. See, just math!

is editorial manager at Morningstar.ca

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