There has been a lot of hype lately surrounding companies that are announcing stock splits. A lot of people seem to get excited over the announcement of some popular companies recently announcing a 4 for 1 and 5 for 1 stock split. If you noticed the action in those stocks, they both ran up tremendously after that announcement. Why all the hype?
Let’s explain the stock split first.
There are actually two types of stock splits, a normal stock split and a reverse stock split. The normal stock split that you have been hearing and reading about in the news recently with the aforementioned names is when a company will give you x number of shares for the number you currently own. For instance, lets say XYZ Tech Company is planning a 4 for 1 stock split. When this was originally announced the stock was trading around $400 a share. Lets say you owned 10 shares of XYZ Tech Company at $400. When the stock splits, you would get 40 shares, but the share price is divided by 4. You originally had $4,000 in XYZ Tech company, 10 shares at $400 before the split. Now after the split, you still have $4,000 of XYZ Tech company, 40 shares at $100. A reverse stock split would be the exact opposite of the normal stock split. You would get less shares at a higher price. For instance, if you had a $5.00 stock that did a reverse split, 1 for 10. If you had 1,000 shares at $5.00 for a total value of $5,000 before the split, then you would have 100 shares at $50 for a total value of $5,000.
Why would a company do a Stock split?
Honestly, the reason a company would do a stock split is much simpler than you might think. In the past it may have had something to do with transaction costs, because brokerage houses made more money on the number of shares they transacted. Today, with so many platforms offering $0 or very low cost trading and now partial share trading, that’s not the priority. More than anything, it has to do with perception. If you take a Tech Company trading at $500 a share, the general public seems to think that’s expensive. If you’re in the industry, you know you don’t look at the share price to determine if a stock is expensive, you look at the Price to Earnings ratio, PEG ratio, or price multiple to projected sales. If a company were to do a normal stock split, the retail trader or general investor now likes the idea that they can own 10, 50, or 100 shares of that Tech Company instead of 2 or 5 shares before the split. Typically companies that do a normal split are increasing in momentum and stock price and want the perception to be that they aren’t expensive to the general public, which could increase more room to the upside for the stock to run now that they have the perception of being less expensive or cheaper, even though that has absolutely nothing to do with it. This perception alone can cause the stock to continue to run before and after the split. People buying into the stock before the split anticipating further room to run and people buying after the split thinking the stock is less expensive.
Why would a company do a reverse split?
When a company announces a reverse split, its for the exact opposite reason. It’s usually because a company’s share price has been beaten down and they need to make it seem like it has more value. This happened after the 2008 Financial Crisis with many of the bank stocks that were beaten down. When your company stock is below $10.00 or $5.00 it looks cheap or undervalued. A company wants to give the perception that they are worth more than what they are currently trading. There are some other reasons depending on the share price that could be preventing the stock from being able to be included in certain funds or it may be more difficult for investors to purchase that stock because they could be considered higher risk and certain platforms may put a limit on many investors to purchase stocks trading under a certain value.
Basically, stock splits in and of themselves do not create any more value. They simply change the perception that is placed on the stock’s value, which could ultimately increase the value of that stock. You must remember that you should always look at a company’s fundamentals and value it on the underlying factors, not the share price alone. With that said, perception can be a very powerful tool.