Stock Splits Explained for New Investors
As someone who closely follows the markets, and manages their own money, I have consistently see people misunderstand stock splits. This usually happens with new investors or traders who suddenly think the company got cheaper or now provides a better value. In reality, a stock split does not change a company’s value AT ALL. In this post, I’ll help anyone and everyone interested in the exact specifics.
Don’t Understand Stock Splits? Think About Pizza.
Imagine you have two identical pizzas that are the same exact size. The only difference between these two pizzas is how they are cut. One pizza is cut into 6 giant slices while the other is cut into 20 small slices. Despite the difference in the number of slices, the size of each pizza remains the same. The pizzas might be cut up differently, but they are still the same exact size. The pizza that has 20 slices is the still the same size as the pizza with 6 slices, but the pizza with 6 slices has much LARGER slices than the pizza with 20 slices.
This is exactly what happens during a stock split. A company keeps its company the same size, it just simply decides to slice up the shares into smaller amounts. The total market capitalization of the company remains unchanged.
The Key to Understanding Stock Splits
The key fact to understanding stock splits is reading the fine details that the company announces. Almost always, a company will say something like “We are doing a 2-for-1 stock split” or “we are doing a 10-for-1 stock split” and this exact phrase tells you how much more they are cutting up the pizza.
When a stock split occurs, the price per share decreases because each share now represents a smaller portion of the company. For example, in a 2-for-1 split, each existing share is split into two shares, and the price per share is halved because now the slices are smaller and the price is adjusted to represent that smaller size.
To many investors, this lower price can give the illusion that the stock is now cheaper and more affordable, potentially driving increased interest and trading activity. However, the overall value of the investment does not change.
Why Do Companies Do Stock Splits?
Company’s do stock splits to boost the stock’s liquidity and make it more accessible to retail investors. Sometimes, this can actually be a bearish situation because it may show a company is desperate to get more buyers involved. Thus, it is reducing the price by cutting up the shares, so that even those with little money can access them.
However, there is no data at this time to specifically say whether or not stock splits make a difference.
One important fact to know, and it’s the bullish case, is that a stock split can be considered a nice thing for companies to do for investors who want to own shares, but may not have the money to buy one. If a single share sells $1,000 each, it will be hard for many young people to access such shares. But, if they do a 10-for-1 stock split, and cut up that single share 10 times, now it is worth just $100 and they can access them. This can be bullish for the brand to help the investors who want to own and expand the ownership pool to include new people.
The Math of Stock Split
I want to now show the math of a stock split and how it works. This way, anyone reading who wants to fact check this explainer can do it. In the example below, I am pretending to show the price per share of a company I made up called Stef’s Super AI Company. Here are the details:
Stef’s Super AI Company
Before the split:
- Number of shares: 1,000,000
- Price per share: $100
- Market capitalization: 1,000,000 shares * $100/share = $100,000,000
Now, suppose Stef’s Super AI Company announces a 2-for-1 stock split. This means that each existing share is split into two new shares. In other words, as we learned above, the pizza gets cut into smaller slices. This is how the math looks.
After the split:
- Number of shares: 2,000,000
- Price per share: $50
- Market capitalization: 2,000,000 shares * $50/share = $100,000,000
As you can see, the market capitalization remains the same at $100 million. The company is still worth the same amount; it is simply divided into more pieces.
The key takeaway for investors is to understand that a stock split does not inherently make a stock more valuable or cheaper in terms of the company’s overall worth. It merely adjusts the share price and the number of shares to potentially make the stock more accessible to a broader range of investors.
By keeping this perspective in mind, you can avoid the common misconception that a lower share price post-split equates to a cheaper stock. Remember, it’s the same pizza, just sliced differently.
Thanks for reading!
I hope this explainer helps all the new investors and traders out there.