Stock Splits And How They May Present Unique Portfolio Opportunities
You’ve likely seen it in the news, and you may have heard of recent companies like Amazon or Google splitting their stocks. But what does a stock split mean? How does it benefit the shareholders? And are these opportunities worth looking into, or should you avoid stock splits altogether?
In this article, we will explore the ins and outs of stock splits to see how they may provide opportunities previously hidden from some investors.
Understanding What A Split Means
A stock split happens when a company increases the number of shares available but does not change the overall value of the company.
For example, if there are 100 shares of XYZ Corp at $10 each today, then after a 2-for-1 split next week, there will be 200 shares of XYZ Corp at $5 each.
Stock splits should not be confused with stock dividends, which are quite different.
A stock split happens when a company wants to keep shareholders’ interest high by increasing liquidity.
A stock dividend is more like a payout that a company provides their shareholders.
Stock splits can offer everyday opportunities to buy into the market's largest companies. However, it’s worth understanding why stock splits happen and what they mean before you start buying up shares.
Why Do Companies Split Their Stock?
A stock split is often a healthy sign to investors. It suggests that a company is thriving. In fact, the company may be doing so well that its stock is now priced too high for the average investor to buy. As a result, the company is splitting its stock to make its shares more affordable.
This practice can be good for everyday investors because it allows them to buy into high-performing companies. It's good for companies because it can improve their liquidity as new investors jump on board.
Not all companies split their stocks, however. Some publicly traded enterprises may want to keep their stock prices high. They generally do this to maintain a certain brand privilege that they've cultivated in the market. Two companies known for maintaining high stock prices are Elon Musk's Tesla and Warren Buffet's Berkshire Hathaway.
Understanding The Importance Of The Divisor
To properly calculate the value of a company's stock, it is necessary to first understand the concept of the divisor.
In the United States, stock splits can occur for all publicly traded companies. This is done in order to increase trading liquidity and makes it easier for investors of all sizes to participate in the market. It also increases the total number of shares outstanding in circulation, which decreases the price per share cost without changing the overall market cap or profitability of the company. The most common type of stock splits is a 2-for-1 deal.
For current shareholders, stock splits do not change the value of their investment. Although stocks are technically worth less after a 2-for-1 stock split, it does not actually change in value. To demonstrate this, let’s use an example: if you own 1 share of Amazon (AMZN) at $500 per share and then Amazon announces a 2-for-1 stock split, you will now own two shares at $250 each. You still own $500 of Amazon, but you now own two shares at $250 instead of one share at $500.
The Potential Impact On Long-Term Returns
While stock splits can be a positive sign of shareholder confidence, it could also be a reason to be wary of certain stocks.
Other than reducing a share's per-share value by making them more affordable to average investors and easier to trade, stock splits do not have much impact on long-term returns. For example, Amazon (AMZN) recently announced a 20-for-1 stock split for its common shares without any material change in capital structure or corporate governance policies.
Staying Focused On Company Fundamentals
A stock split is simply a non-event and shouldn't trigger a change in strategy. Generally, when someone is investing in individual stocks, they are looking for good businesses with strong fundamentals, regardless of whether a company's shares are trading at $0.05 or $100 per share.
For most established investors, it’s likely you already held the stock if it was in line with your overall investment strategy. For an investor with a smaller portfolio or fewer dollars invested, a stock split may be an opportunity to buy a particular stock or to rebalance your existing portfolio. But, your investment strategy and goals should drive that decision, not the cheaper stock price on its own.
Questions That Should Be Answered
In short, stock splits do not necessarily affect your current holdings, but they might present an opportunity for further diversification. You may consider rebalancing your portfolio or selling off part of an existing position to make room for a different stock.
What Are the Two Most Common Forms of Stock Splits?
There are two main forms of stock splits: reverse stock splits and forward stock splits.
A forward split occurs when a company increases the number of outstanding shares held by current shareholders.
Let's say you are a shareholder in Company X. You own 100 shares and every share is worth $50, providing you with a complete amount of $5,000. Company X soon decides to try a 2-for-1 forward increase.
Now you have two shares for each one share that you just owned, or a total of 200 shares, with each share now worth $25. Although you now own twice as many shares, your investment within the company remains identical at $5,000. A forward split is the commonest kind of equity restructuring.
A reverse split is essentially the opposite of a forward split. Whereas a company with 10,000 shares trading at $20 per share would see its shares increase in price with a forward split, that same company would see the number of shares fall with a reverse split.
Is It Best to Buy Before or After a Stock Split?
A stock split may provide you with an opportunity to add to your portfolio.
If there is bad news about a company or a sector, however, it may be best to wait until after a stock splits before buying new shares. Why? When you buy shares of a company after they’ve performed an equity offering (stock or debt), you may pay less than those who bought shares prior — of course, this isn’t always the case.
What Are Some Examples of Stock Splits?
Stocks that are subject to a stock split experience their share price divided by a set amount. For example, if a stock with a share price of $10 underwent a 2-for-1 split, investors would receive an additional share for every one they owned.
Amazon’s most recent 20-to-1 split broke down like so: Originally trading at around $2,785.58 apiece, AMZN stock was hit with a 20-to-1 stock split on July 19—meaning that on any given day after that date, each single share was worth about $139.28. In Amazon's case, the day its stock split, AMZN shares rose 6% (but this doesn’t always happen).
Do You Make or Lose Money When a Stock Splits?
As a general rule, you could make money in a stock split because you might be able to buy more shares at lower prices. Like anything else in the market, though, there is no guarantee that the stock will appreciate or that a stock split will work to your advantage.
By itself, a split doesn't make your shares any more or less valuable than they were the day before the split occurred. It can, however, attract new investors to the company, causing share prices to rise over time.
Sometimes, investors worry that a split will affect their dividends or create capital gains tax. In general, these issues are handled automatically when the split takes place and they’re usually considered a non-taxable event. It may be a good idea to call your advisor, though, and adjust any automatic buy-or-sell orders you have in place after a split.
Are there any tax implications to a stock split?
There can be minor tax implications surrounding stock splits.
The split itself does not affect your taxes, according to the IRS, because the value of what you own hasn't changed. For a taxable account, you only pay taxes on any income or profits you make when you sell your stock, not fluctuations in value that happen while you hold your stock. You might, however, need to adjust your per share basis, which is generally done automatically if shares are held electronically.
If you own stock that recently split, you probably have nothing to worry about. In fact, it might be a sign that you've invested in a strong, flourishing company.
If you do have questions about your investment portfolio, feel free to contact us at Cooke Wealth Management to set up a time to talk. We'll be glad to answer your questions.