Have you ever wondered why some stocks have share prices that are within reach and others are so high they seem unaffordable?
Why does it cost hundreds of thousands of dollars to buy one share of Berkshire Hathaway while it costs you no more than the cash in your wallet to buy one share of many other stocks?
When share prices rally, some stocks split while others do not. So what is this process that keeps share prices within reach of most traders?
How Do Stocks Split?
When stocks split, the number of shares you own increases but the price per share reduces proportionately.
When a company’s Board of Directors decides to increase the number of shares outstanding by issuing more shares, a stock split takes place.
Current shareholders may receive two shares for every one they own in a 2-for-1 split or three shares for every two they own in a 3-for-2 split.
These are the most common stock split ratios but others are known to occur too, such as 3-for-1 or 4-for-1. There is no theoretical limit to what split ratio can be selected. For example, Apple [AAPL] split its shares 7-for-1 in 2014.
When you own shares of a company and a stock split takes place, you receive more shares but sadly that doesn’t mean you end up any richer.
Let’s say you owned 100 shares of stock trading at $50 per share, so the value of your shareholding is $5,000. After a 2-for-1 stock split, you own 200 shares, but the share price is cut in half.
A stock split increases the number of shares but reduces the share price proportionately so the overall value doesn’t change.
VALUE BEFORE: 100 shares * $50 = $5,000
VALUE AFTER: 200 shares * $25 = $5,000
So, after a stock split you will own more shares but the market capitalization of the company doesn’t change and so your holdings will be worth the same.
Why Do Stocks Split?
Stocks split primarily to make the price per share more affordable to investors, thereby increasing the demand for shares, which can in turn drive share prices higher.
The main reason stock splits occur is to make it easier for investors to buy shares.
Two competing philosophies occur when it comes to stock splits. Some company directors, such as Warren Buffett and Charlie Munger, do not believe in stock splits. As a result, to buy just one share of Berkshire Hathaway costs hundreds of thousands of dollars.
It has been reported that Warren Buffett influenced Larry Page and Sergey Brin, founders of Google, who have not split the share price of Alphabet [GOOG] based on the same philosophy.
More often than not when a share price climbs so high that buying a single share costs hundreds of dollars, the Board of Directors will declare a stock split.
As the share price becomes more affordable, investors who could otherwise not afford to buy shares scoop them up, thereby increasing demand for the stock. This increased demand can drive share prices higher. However, over the long-term fundamental factors, such as earnings, return on invested capital, and revenue growth, influence share price most.
>> More: Is Netflix Stock A Buy Or Sell?
What Happens To Options Prices
When Stocks Split?
Options strike prices are affected by stock splits. If a stock splits 2-for-1, the number of options contracts you hold doubles and the strike price halves.
When stock splits take place, options on the underlying stock are affected too. The same way a company’s share price splits, so too do the options strike prices of the underlying stock split.
Imagine you owned 10 call options at a $50 strike price on a stock that was trading at $50 per share, and each option was worth $4 per share or $400 per contract.
When the stock splits 2-for-1, the new share price is $25. But what happens to your call options?
You will now own twice as many call options at a strike price that is half the original strike price. So you will own 20 call contracts at strike $25 worth $2 per share or $200 per contract.
The total value of your calls is unaffected by the stock split just the price of your stock and options contracts are affected.
VALUE BEFORE: 10 contracts * $4 * 100 shares/contract = $4,000
VALUE AFTER: 20 contracts * $2 * 100 shares/contract = $4,000
What Is A Reverse Stock Split?
A reverse stock split reduces the number of shares you own but increases the price per share proportionately.
No matter what the market capitalization of a company, stock exchanges will often delist share prices that fall below a certain threshold.
Delisting is a significant event for a company because many exchange-traded funds and mutual funds are contractually required to hold stocks traded on the most reputable exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ.
When a company is delisted, these funds are required to sell shares of the company, which can catalyze a downward spiral in share price.
Sometimes a company doesn’t have a choice and is involuntarily delisted. But when the company has a choice to remain on a major exchange, it can follow a process known as a reverse split.
In a reverse split, a company will increase its share price by reducing the number of shares outstanding.
Imagine you own stock in a company trading at $2 per share. The Board of Directors decides to increase the share price to $20 to garner more respectability and avoid the risk of delisting, but how does it achieve this?
By issuing a 1-for-10 reverse split, the company can increase the price 10 fold without changing the valuation whatsoever.
If you own 1,000 shares of the $2 stock before the reverse split, then afterwards you would own 100 shares trading at $20 per share.
VALUE BEFORE: 1,000 shares * $2 = $2,000
VALUE AFTER: 100 shares * $20 = $2,000
Even though you own only 100 shares after the reverse split compared to 1,000 beforehand, you can see that the value of shares held is unchanged because the price per share has increased 10x.
The Bottom Line Of Stock Splits
Stock splits make share prices more affordable to retail investors. When stocks split, lower share prices attract more investors, thereby increasing marketplace liquidity.
Reverse stock splits are a way for companies to garner more respectability by increasing share prices without affecting market capitalization and are sometimes a way to sidestep the risk of delisting.
To see whether stocks you own have a split on the horizon, take a peek at a stock split calendar.
Have you owned a stock when a stock split took place? How did you fare? Share your comments with us below, we would love to hear from you.