A stock split can be interesting for you as an investor. But what exactly is a stock split? Can you benefit from it? In this article, we explain this concept in more detail.
During the Internet boom in the late 90s, stock splits were commonplace. Stock prices rose so sharply during this period that publicly traded companies split their shares so that they remained affordable to private investors. Cisco did it regularly. Between 1991 and 2000, the software developer conducted no fewer than nine stock splits. It was also a tried-and-true method for Apple, with multiple splits.
What is a stock split?
The term 'stock split' actually says it all. In this process, a company splits each share into smaller pieces at a certain split ratio, but the value of all the shares together remains the same. For example, if the company announces a two-for-one stock split, the share count doubles, and the share price halves.
Reasons for a stock split
Even today, we often see stock splits. For example, giants Tesla and Apple announced stock splits last year. Our own stock, flatexDEGIRO AG, was still split five-for-one in 2021. With stock splits, companies try to make their shares more attractive to retail investors and increase marketability. Private investors generally prefer to buy 100 shares of €10 rather than 10 shares of €100. A lower price makes a stock accessible to a larger group of investors and provides more liquidity in the stock.
Example of a stock split
Company XYZ has 10 million outstanding shares and they are traded at a market price of €100. The market capitalisation is then €1 billion (10 million*€100). Suppose the company's board decides to do a stock split at the ratio of 2-for-1. Immediately after the split, the price automatically halves to €50, and the number of outstanding shares doubles to 20 million. The market capitalisation still remains €1 billion. If you had 10 shares worth €100, you will own 20 shares worth €50 after the split. You still have a total of €1000 worth of XYZ shares in your portfolio.
The most common split is 2-for-1. However, numerous ratios are possible. Think of 5:1, 7:1, 10:1, 3:2 et cetera. In the latter case, for every two shares the shareholder receives three new shares, or the outstanding number of shares increases by 50%. If you had 10 shares worth €60, you will have 15 shares worth €40 after the split. In order to carry out a split, however, the board of directors needs the consent of the shareholders, who can vote on it at the shareholders' meeting.
What is a reverse stock split?
Companies can also carry out what is known as a reverse split. This is basically the opposite of a stock split. In a reverse stock split, the number of outstanding shares is reduced and the par value per share is increased by the same factor. Construction group Heijmans, for example, carried out a reverse split of 1:10 in 2009. In this process, 10 ordinary shares with a nominal value of €0.03 were combined into 1 ordinary share with a nominal value of €0.30. A reverse split also has no effect on a company's market capitalisation. If the share price is quoted at €0.03 on the day prior to the split, it will be €0.30 thereafter in this case. Shareholders with 1000 Heijmans shares would have 100 shares after the reverse split. The total value remains €30.
A reverse stock split is thus purely a cosmetic operation, which companies carry out because of the negative image of a low-priced share or penny stock. Such a stock is often a plaything of speculators and can therefore exhibit large price fluctuations.
Advantages and disadvantages of stock splits
For companies, a reverse split often marks a fresh start after a difficult period when the stock price has fallen sharply. But it does not make the profit outlook better or worse. However, the attractiveness of the share can increase. Stocks with a low share price can have a negative image.
Unlike reverse splits, companies choose an ordinary stock split from a position of strength. After all, a stock split generally takes place after the price of a stock has risen sharply due to, for example, a strong increase in profits or the prospect of future growth. Investors see the split as a positive signal that the profit outlook is also fine. After the split, there will be more room for a further price increase. Another additional benefit is that tradability improves, reducing the difference between bid and offer prices. The announcement of a stock split generally has a price-increasing effect. However, this is temporary. Ultimately, earnings per share is what drives stock prices in the long run.
Shares that have been rising sharply in value for a long time are in danger of becoming unaffordable for private investors. There are stocks with a price of €10,000 or more. A well-known example are the Class A shares of Berkshire Hathaway, Warren Buffett's investment company, which is currently quoted at $425,725 (€387,171). Closer to home in Europe, Swiss chocolate manufacturer Lindt & Sprüngli takes the crown, with a share price of nearly €112,000 converted.
For the small investor, these shares are out of reach. Liquidity therefore leaves something to be desired. This is also the reason why Warren Buffett's investment vehicle is not included in important stock indices such as the S&P 500. However, the world-famous investor has never wanted to split his share. Indeed, a split would go against his renowned buy-and-hold investment strategy. According to Buffett, a high share price ensures that speculators looking for a quick profit stay away.
Nevertheless, Berkshire Hathaway introduced the so-called B shares in 1996. These represent one fifteen-hundredth of a regular share and therefore have a much friendlier price tag of $283.54 (€251.87) at the time of writing. Thus, Buffett's investment company is still accessible to the small private investor.
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The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Please be aware that facts may have changed since the article was originally written. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.
Sources: Investopedia, FD