Recently there have been some notable names undergoing stock splits. Stock splits can be the subject of some confusion among investors, so we wanted to delve into the mechanics of stock splits and what they mean for investors.
Stock splits come in two varieties: a regular stock split (hereafter referred to as “stock split”) and a reverse stock split. With both stock splits and reverse stock splits, the market capitalization of the company remains unchanged — only the number of shares changes. This effectively changes the per share price of the company, while maintaining each investor’s proportionate ownership in the company.
Following a stock split, the investor will own the same amount of the company, they will just have a larger quantity of shares at a lower price than they were previously. Following a reverse stock split, the investor’s ownership is the same, but they will own a smaller quantity of shares at a higher price than they were previously. No matter if it’s a regular stock split, or a reverse stock split, the investor is left in the same position as before. Further on in this article we will illustrate this with some numerical examples.
Many people believe that when a board of directors splits the company’s stock or announces a stock dividend, shareholders get something for nothing. This, of course, is not true. Others think that a stock split means the stock is “on the move” and therefore will go up. There’s more truth to this notion than to the something-for-nothing one, but not much. Consequently, instead of searching for stocks that seem on the verge of splitting, you’d probably do better to simply buy companies with strong growth prospects.
A stock split is nothing more than the division of a corporation’s outstanding common shares into a larger number of shares, according to a formula like 2-for-1, 3-for-1, 5-for-1, 20-for-1 etc. The usual reason it’s done is to create interest in the stock among a wider group of investors by lowering the per share price. It can also make it more attractive for a company that offers share purchase plans for their employees as it’s more accessible for employees to purchase whole shares of a company.
By splitting, companies allow everyday investors to buy shares as it makes the shares more accessible for investors who wish to buy them. Some self-directed investment options do allow investors to buy fractions of whole shares; however, we caution investors against that as the transaction costs can add up, and you may be missing out on dividends.
The belief that once a stock splits its price will rise stems from the fact that — if only for psychological reasons — many investors do prefer cheaper shares. Therefore, a $120 stock that suddenly costs only $60 (or even $30 in a 4-for-1 split) achieves instant affordability to many investors who might have balked at paying the original price.
News of an impending stock split may well cause a flurry of buying by bargain hunters, which indeed pushes the stock price up. This advance, however, is usually only temporary. Split stocks often normalize back to their normal price trajectory within a relatively short time.
Splitting can also make the share price appear more stable initially, when in reality it is not. For example, a stock whose share price moved $10 in a day but had a 4-for-1 stock split will have its share price move $2.50 in a day. While the change in dollars after the split looks more attractive at first glance, it is no different in terms of the percentage change.
With reverse stock splits, action is usually taken to improve the optics of the company. There is the false perception that if it has a higher share price it is a more valuable company. Meanwhile, there is no impact on the overall market capitalization or value of the company. Some organizations such as charities or foundations have an Investment Policy Statement which limits or prohibits the purchase of stocks trading below a certain price. When a company does a reverse stock split, this immediately brings their stock back into consideration for these organizations.
Running the numbers
When 50 million shares trading at $500 each split 2-for-1, the immediate result is 100 million shares trading at $250. Shareholders end up with precisely the same proportionate investment in the company as before the split.
The same is true for reverse stock splits, but as the name suggests, in reverse. If there are 50 million shares trading at $7 each and the company does a 1-for-2 reverse stock split, there will then be 25 million shares trading at $14 apiece.
Date the split was announced
Prior to a stock split, a company will first make a public announcement that they plan to split. This announcement will also contain important details such as when it will happen, and the split ratio (i.e. 2-for-1, 3-for-1, etc.).
The record date is also known as the ex-date. This is the date which you must own the security in order to be eligible to receive the additional shares in the company. That being said, the right to receive the new shares transfers with the securities if bought and sold in between the record date and the effective date.
The effective date is the date that the stock begins trading at its new per share price, and the date that the updated quantity of shares will be updated in the client’s investment accounts.
What does a stock split look like in my investment account?
As of the effective date, the newly split price the shares are now trading at will reflect on the effective date. However, it is quite common for the new quantity to only reflect after a minimum of one or two days. With a stock split, this will give the appearance that the account value went down. For a reverse stock split, it will give the appearance that the account value has gone up. Once the stock split has settled, the account will be back to its standard market value.
As mentioned above, stock splits may cause a short-term flurry of activity and excitement surrounding a stock; however, as an investor you are not getting anything for free out of it. It’s important to focus on high-quality companies with long-term growth and/or dividend potential. If one of those companies happens to split in the future, then it’s likely done well for some time, and you have benefited from that long-term growth.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email email@example.com, or visit greenardgroup.com.