In theory, the skyrocketing of a company’s stock price should be nothing but a good thing, right? Not for everyone. A stock with a huge price tag per share could frighten away smaller investors, who may perceive the stock as too rich for their blood. That means that many investors might pass over the company’s stock for more affordable stock choices, sometimes even the stock of competitors.
Despite the company’s healthy (and increasing) stock price, the investors may stay away in droves, and that is not good news for a company trying to grow its number of stockholders.
So what’s a company to do? One idea that seems to be time-tested: split the stock (generally called a standard stock split). That means artificially bringing down the price of the stock shares, so that they look more attractive to more investors, even though the value of the company remains the same. The investors get in the game, and the company gets more marketability and liquidity.
In effect, therefore, stock splits are a signal from management that they have confidence in the continued appreciation of their companies’ shares, says Marketwatch .
When Do Stocks Split?
Corrections and perceptions can sometimes influence prices on a stock exchange even more than reality. Wielding this market insight, a company will split its stock if they see that its share price is rising to amounts much higher than other companies in its sector.
The idea is to give the perception that its shares are as affordable—or even more affordable—to investors. In reality, the value of the company has not changed, but the stocks now look more affordable, especially to smaller investors, to whom this matters.
How a Stock Split Affects Stock Price
After the stock splits, the stock’s price usually goes down proportionately. That’s because the number of outstanding shares has gone up. 10 shares at $10 is worth the same as 20 shares at $5. Both are $100.
The stock price may change after a split but the market capitalization stays the same. A cooler way to say this is “market cap.” (try it!). Market cap is the total dollar value of a company’s outstanding shares.
Investors look to the market cap when they want to know the size of a company. Company size is different than its sales numbers or total assets owned. The market cap helps investors figure out the aggregate value of a company’s worth.
Here’s the math (and it’s easy): if a company has 20 million shares priced at $100 a share, the company would have a market cap of $2 billion. Simply multiply the number of shares by the price of each share: 20 million x $100 = $2 billion.
Can a Stock Price Rise After a Stock Split?
Yep. It’s a supply-and-demand thing. Small investors may get hip to this stock when it splits and becomes more affordable. The mad rush boosts demand of the stock and makes its price rise. Usually this affect is moderate since most investors realize that a stock split does not actually change the value of the company.
Another way the split-stock price could rise is the perception that, because the company split the stock, the company’s share price has been steadily rising, and will keep going. This will increase demand and also the stock price.
An Example of a Well-Known Stock Split
Apple Inc. split its shares 7-for-1 in June 2014.
Why use the 7? According to Apple Insider, it’s a less familiar transformation, which may have been chosen on purpose, in order to reset the market’s expectations of where Apple “should” be trading.
It’s a mind trick. Apple Insider says, “After a two-year period of irrational stock moves, Apple may likely want to erase the mental barriers investors may have about where Apple trades, as well as breaking any psychological links between Apple’s share price and that of other companies one might compare it against.”
“Dividing the stock price by 7 results in an entirely new set of numbers that aren’t easy to mentally translate in comparisons with past expectations. This is similar to how a tourist—in a country where the local currency is an unfamiliar fraction of the value of the currency his expectations are set in—now looks at prices in a new way.”
The mind trick worked, and well. The stock became more affordable to smaller investors. Before the split, each share traded at $645.57 (wow!). After the split, the price per share was $92.70.
The math: 645.57 divided by 7. The $92.70 is approximate.
For the lucky shareholders who already held Apple stock, each was given six additional shares for each share they owned. If a stockholder held 1,000 shares of Apple, they would have 7,000 shares after the split.
As a result, Apples’ outstanding shares increased from 861 million to 6 billion shares. The market cap, of course, remained unchanged: $556 billion.
The first day after the stock split, the share price immediately increased to a high of $95.05. This was likely a result of the demand spurred by the lower stock price.
While we’re focusing on numbers, here’s a good rule of thumb to understand how it works: if you own a 2-for-1 stock split, that means you now own twice as many shares, but each share’s worth is half as much as the original price.
What Is A Reverse Stock Split?
This tactic is used by companies who have the opposite problem: their share prices are too low, and they want to increase their prices. If a stock price descends down too far, the stock exchange can “delist” it, meaning removing it from the exchange.
For example, in a reverse 1-for-5 split, 10 million outstanding shares at 50 cents each would now become 2 million shares outstanding at $2.50 per share. In both cases, the company is still worth $5 million.
In May 2011, Citigroup reverse split its shares 1-for-10 in an effort to reduce its share volatility and discourage speculator trading. The reverse split increased its share price from $4.52 pre-split to $45.12 post-split and every 10 shares held by an investor was replaced with one share.
While the split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares, the market cap of the company stayed the same at approximately $131 billion.
Hoping to leverage some price movements around a stock split? Some stock exchanges like NASDAQ , offer a chart featuring upcoming stock splits. The information given includes the split ratio and when the split is payable.
Investing with SoFi
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