What Happens When a Stock Splits?

Every publicly traded company or corporation has a set number of outstanding shares. These shares encompass stocks currently held by the shareholders, restricted stock held by employees or insiders and share blocks held by institutional investors. Based on investor demand, outstanding shares can rise or fall in value. Sometimes the outstanding share prices may increase significantly, dissuading average retail investors from investing or making it harder to sell the shares. 

To reduce the price per share, the company may either pump out more shares to dilute existing shareholders' shares or split existing shares into smaller units without changing the total value. The latter is referred to as a stock split and may impact how investors approach their portfolio in the market. For instance, suppose you hold a short position on a stock having a forward split. In that case, the shares will be debited from (not credited to) your account, thereby increasing your short position without an increase in short value. 

When you hold a company's stock that executes a split, your position details are impacted while the value remains unchanged. Benzinga takes a deep dive into stock splits, providing insight into how you can better prepare for the sometimes startling changes that may occur to your position on the day of the split.

What Happens During a Stock Split?

Stock splitting is a corporate action undertaken by the board of directors that involves dividing a company's shares outstanding into smaller or larger share units. A stock split changes the number of outstanding shares of a company's stock without changing the shareholder's ownership percentage in the company. The company's overall market capitalization remains unchanged. A stock split can either be forward or reverse. 

What is a Forward Stock Splitting? 

A forward stock split (share subdivision) is the most popular form of stock splitting. It involves dividing the company's outstanding share counts without changing its overall market capitalization. The implication is that the available outstanding share number increases while individual values of each share decrease by a proportional amount. Current or existing shareholders are issued additional stock for every share they hold. However, the value of their stakes remains unchanged.

For instance, suppose you currently hold 10 shares of XYZ company valued at $300 per share, and a 3-for-1 stock split is executed. In that case, you'll have 30 shares worth $100 per share. Here the total dollar value of your portfolio remains $3,000 ($300 * 10 or 30 * $100). 

Amazon.com Inc.'s (NASDAQ: AMZN) 20-for-1 stock split that took effect in June this year saw existing shareholders receive 20 additional shares for each unit of shares they owned at the time. Dividing existing company shares into 20 new shares implies that each share will be worth one-twentieth of the original value. 

The new affordable share price of the stock after splitting makes it more attractive to retail investors and increases demand for the share while boosting liquidity for the company. 

What is a Reverse Stock Split? 

In contrast to forward splitting, a reverse split (or share consolidation) reduces the company's outstanding shares. A reverse stock split occurs when a company condenses multiple units of its shares into a single share that trades at a higher price point. However, like the forward split, the company's market capitalization and the value of each shareholder's stake remain unchanged. While a forward split is considered bullish, a reverse split often signifies bearish sentiment, and as such, you must proceed with caution.

Suppose company ABC announces a 1:100  reverse split. Shareholders will receive a unit share for every 100 shares they own. If you own 2,000 shares of ABC at $10 per share ($20,000 in total dollar value) before a reverse split, you would own 20 shares at $1,000 per share after the reverse split, maintaining the $20,000 value. As explained earlier, your number of shares change while your monetary investment remained unchanged. 

Reverse splitting is often executed by small-cap companies to avoid being delisted from a major stock exchange when nearing the minimum allowable share price. Such companies might also execute reverse splitting to improve their public image or appeal to certain institutional investors who might be unwilling to buy a stock priced below specific amounts. Micro-cap companies and companies that trade in the over-the-counter (OTC) markets are also more likely to carry out a reverse split. 

Big companies trading on major exchanges are also known to carry out reverse splitting. For instance, in May 2011, Citigroup Inc. (NYSE: C) executed a reverse split of its shares 1-for-10 in a bid to minimize volatility and discourage speculative trading. The measure increased its share price from $4.52 to $45.12 and reduced its outstanding shares from 29 billion to 2.9 billion, while market capitalization remained unchanged.

Stock splits come with a ratio — the split ratio, representing how many shares will get issued at the end of the split and the specific type of split involved. In forward splitting, a larger number precedes the smaller number (10-for-1 or 10:1). The reverse is the case for reverse splitting. 

Why Do Corporations Complete Stock Splits?

A company may consider stock splitting for a variety of reasons. Because the reasons that a stock could split are so diverse, you need to make certain that you match the situation to your portfolio. You shouldn’t be excited by every stock split because some are perfect for you and some are not. Some of these include the following actions.

Increase Demand via Affordable or Desirable Share Price 

A psychological barrier may occur when trading high-priced shares. For instance, most retail investors may find a share price of over $3,000 intimidating, either based on financial reasons or fears that such a company stock has little room for growth (or price appreciation). Berkshire Hathaway Inc. Class A (NYSE: BRK-A) shares traded at $480,28. per share at the end of November 2022. Its all-time high of $544,389 recorded on March 29, 2022, was even more staggering. 

Such astronomical share prices create psychological and financial barriers that make the shares unattractive to most investors. Splitting a stock can make it more appealing and attractive to investors. In forward splitting, the share prices become more affordable to average retail investors, increasing share demands. In reverse splitting, the consolidated share price makes it more appealing to investors wary of stocks trading below specific prices. 

Increase Liquidity 

Forward stock splitting enhances trade continuity and cushions liquidity risks by reducing the stock's bid-ask spread. A reduced bid-ask spread makes for more efficient trading, increasing share demands. Reduced liquidity risk may lower the cost of equity capital since investors will then require lower liquidity premiums. 

Inclusion in Dow-Jones Industrial Average (DJIA) 

A company may consider forward stock splitting to fast-track its inclusion in the DJIA, which tends not to include high-priced shares. Unlike other price indexes that are market-capitalization weighted, the Dow is a price-weighted index. When a company's stock is added to Dow, index funds that track the DJIA might buy its shares. This factor can slightly increase the share price or value, other things being equal. However, with price-weighted indexes, you can't directly compare two companies to know which is more valuable.

Enhance the Company’s Market Perception

A reverse stock split can help improve how investors or the market perceive a company, especially for small and micro-cap companies or penny stock companies trading in OTC markets. By consolidating the price, the company maintains listing compliance and lowers volatility.

Publicity 

Although companies hardly carry out a stock split for publicity reasons, stock splitting spotlights a company since it rarely happens. When a company is in the news, it may arouse interest among investors who ordinarily may not know about it or want anything to do with it. Subsequently, such investors may consider taking a shot at buying the company's stock. Publicity can significantly increase daily volatility to benefit day traders. 

What Should Investors Do When a Stock Splits?

For investors, understanding the key dates preceding a stock split and events happening on each date is central to knowing the appropriate action to take. Four key dates matter, listed here in chronological order.

Announcement date: The company will publicly announce the plan to split its stock, providing core details like split ratio and when it will happen. The announcement will also shed light on the preceding sequence of dates below.

Record date: The record date marks when existing or potential shareholders must own the company's stock to be eligible for new shares created by a stock split. 

Distribution date: The distribution date is when investors receive the additional or split shares in their brokerage account. The split share may not be effective at this date, especially if it happens during market closing heading towards the weekend. 

Effective date: The effective date represents the date the split takes effect, and the share is traded on exchanges on a split-adjusted basis. In some cases, the distribution date is subsumed in the effective date as the split can take effect immediately after it shows up in investor brokerage accounts. However, this is rarely the case, as the extra shares mostly show up at market closing.

What happens when you buy or sell shares between the record date and the effective date? When you sell your shares before the distribution date, you lose your right to receive the additional shares from the stock split. The reason is that a record holder's right to receive the additional shares transfers with the stocks when they sell the shares. The right to receive the extra share is referred to as "the due bill," and by selling before the distribution date, you also sell your due bill. The same applies when you sell before the record date. However, when you buy before the distribution date, you acquire the due bill and will receive the additional shares from the split. However, it might be delayed by a day or two. 

The vital thing to know is that a stock split doesn't impact the overall value of your investment in any discernible way. It only changes your number of shares. Although there's a consensus in the investment community and even some evidence that companies who exercise a stock split perform, this market movement only happens in the short term. Prices may rise slightly in the near term as the shares become affordable to new investors. However, without solid earnings or dividend growth, gains recorded after the split will be erased, and the stock will fall back to its pre-split value or lower. 

A stock split is a corporate action that doesn't necessarily improve the long-term growth prospects of the underlying company or its stock valuation. You could even attribute the short-term price surge to short-term volatility or omitted variable biases.

So should you buy a stock split? A stock split may have a positive effect on your portfolio. A reduced price in the forward split can drive up demand and trading volumes, enabling you to get a better price for your shares and earn great returns short-term. However, you must understand that the situation often differs, and a stock split may not improve the value of your investment or the company's profitability over time. So when a high-priced stock of a company in your watchlist splits, you should take your time to conduct due diligence before buying. 

Before investing, you should look into the company's objectives, financials, competitive landscape, management team, risk constraints and other factors that may impact performance. 

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