What Is a Stock Split and How Does It Impact Your Portfolio?

The free market dictates the price of every publicly traded company’s stock. All share prices exist at the intersection of what the seller is willing to accept and what the buyer is willing to pay.

Sometimes, companies want to make their stock more affordable without lowering the collective value of their shares. They achieve this through stock splits — or, if they want to increase the price, reverse stock splits.

What Is a Stock Split?

If a company determines that its stock price is too high, it can lower the value of each share by increasing the number of outstanding shares through a corporate action called a stock split.

For example, suppose XYZ Corp.’s stock is selling at $1,000 per share. The company thinks that’s too pricey, so the board approves a 2-for-1 stock split. The company grants each shareholder an additional share for each share they already own. The value of each share is cut in half to $500 each since there are now twice as many shares.

If you had 100 shares of XYZ Corp. at $1,000 per share the day before the split, you now have 200 shares of XYZ Corp. at $500 per share.

Your investment is still worth $100,000.

Stock Splits and Market Cap

A company’s value on the stock market is determined by its market capitalization, which represents the combined value of all the company’s shares. You determine a company’s market cap by multiplying the price of one share by the total number of outstanding shares.

Although a stock split changes both the price and the number of a company’s shares, the combined value of those shares — the company’s market cap — always remains the same.

What Is a 2-for-1 Stock Split?

A forward 2-for-1 stock split — sometimes stylized as 2:1 — occurs when a company doubles the number of outstanding shares and cuts the value of each share in half. According to Fidelity, it is the most common type of split, although, as you’ll soon learn, it’s not the only one.

The previous example of XYZ Corp. represents a 2-for-1 stock split — shareholders ended up with two shares worth half as much for every one that they owned before the split.

What Does a 4-for-1 Stock Split Mean?

Just as a 2:1 stock split cuts a company’s shares in half, a 4-for-1 stock split divides each share into quarters. In this case, the post-split company will have four times as many outstanding shares, each worth a quarter of the original, as will the company’s investors.

In July, GameStop — the fairytale stock at the center of history’s greatest short squeeze — announced a 4-for-1 stock split. That’s just one of many tech-related splits that have made headlines recently — and they’re not all based on even numbers.

On Aug. 4, Tesla shareholders approved a 3-for-1 split, CNN Business reported. This will triple the number of company shares while reducing the value of each by a third. Tesla shares will start trading on a split-adjusted basis on Aug. 25, the company announced in a press release. It will be Tesla’s second split in as many years.

Some companies go really big, flooding the market with cheap shares.

Just this summer, Amazon split its shares 20:1, as did Alphabet. Shopify enacted a 10:1 split.

Here are a couple of other stock splits that attracted a lot of attention.

Apple

In 2014, Apple split its stock 7-for-1 to bring the price from about $140 a share to about $20 a share. Six years later, the stock split again, this time at a 4-to-1 ratio. In all, Apple has split its stock five times in its history.

Tesla

In 2020, Tesla split its stock 5-to-1. This cut the electric car maker’s share price from about $2,250 per share to about $450 per share. It has since more than doubled to $925 as of Aug. 4, as yet another split — this time 3:1 — looms on the horizon.

What Is a Reverse Stock Split?

Just as a stock price that is too high can be a burden to corporations, so too can one that’s too low. In those cases, companies will sometimes do a reverse stock split, in which they exchange one share of stock at a higher price for several shares at the current, lower price.

It is the opposite of a forward stock split.

Suppose you own 100 shares of ABC Corp., which is currently trading at $6 per share. The company decides to do a 1-for-2 reverse stock split. You now own 50 shares of ABC Corp., but it’s trading at $12 per share.

In 2003, Priceline.com, now known as Booking Holdings, went through a 1-to-6 reverse stock split, going from roughly $4 a share to about $25 a share. It seems to have worked out — as of Aug. 4, Booking Holdings was trading at $1,947.25.

Why Would a Company Split Its Stock?

Companies conduct stock splits for two reasons.

First, splits make company stock more affordable to everyday investors by reducing the price of an individual share by half or more.

Second, splits increase the number of shares on the market by double or more. The Amazon and Alphabet splits each multiplied the number of outstanding shares by 20.

Adding shares increases the stock’s trading liquidity. The more liquid a stock — the more of its shares that are being traded on the open market — the more quickly and efficiently investors can buy or sell shares. Since liquid stocks can better hold their value during heavy trading, higher liquidity is associated with lower risk.

Is a Stock Split Good for the Stock?

Companies typically conduct stock splits when the share price rises so high that it’s prohibitive for new investors. In terms of investor psychology, that dynamic can boost a stock’s prestige and increase demand.

A split usually indicates that previous shareholders were rewarded with so much growth that the stock got too expensive — and who wouldn’t want to jump on that wagon once the cost of admission became affordable again?

Even so, not all companies engage in splits. According to NextAdvisor, some stocks work the same psychology in reverse — as the price rises, the stock’s allure grows, and the more coveted its shares become.

This typically plays out with growth companies, which tend to consider soaring share prices to be evidence of their success. Value companies, on the other hand, are more likely to split their shares to entice new investors with a lower stock price.

Ironically, the world’s most legendary value investor, Warren Buffett, is the CEO of the world’s most legendary anti-splitting company, Berkshire Hathaway.

Famously, Berkshire has never split its Class A shares, which are trading at $442,149 as of Aug. 4.

Who Benefits From a Stock Split?

So while a stock split technically doesn’t add or remove value, it can be good for the company and the shareholder who couldn’t have afforded a share otherwise — but the wealth gets spread around.

As an example, Kiplinger cited Nvidia, which rallied 20% between its most recent stock split announcement in May 2021 and the actual split just two months later in July.

It’s not unusual for news of a split to cause such rapid and dramatic gains. Kiplinger cites three prevailing theories as to why:

• Lower prices open the door to investors who were previously priced out, which increases demand and therefore prices.

• Investors see the news as an indicator that the previous gains that forced up the pre-split price in the first place are going to continue.

• Corporations use splits as signals to deep-pocketed investors that their companies are sitting on unrealized growth, which results in a cascade of large purchases in a short time period.

Is a Stock Split Always Good for Shareholders?

A stock split is neither good nor bad. It is a purely cosmetic corporate undertaking that does not impact the value of the stock, either to the company or to shareholders — at least on paper.

As previously stated, a forward split — which increases the number of shares and lowers the price per share — can be a good thing for both the company and its shareholders.

On the other hand, according to NextAdvisor, reverse splits are essentially an admission that things are bad and getting worse. Sometimes foundering companies resort to reverse splits because they’re at risk of being delisted from an exchange if they’re approaching the exchange’s minimum share price. In other cases, it’s a media move designed to attract the attention of analysts or major investors.

A reverse split is generally a major red flag that a company is struggling, according to Robert Johnson, a professor of finance at Creighton University’s Heider College of Business. As NextAdvisor reported, Johnson suggests that investors avoid companies that are considering reverse splits and, if they’re already current shareholders, that they sell when a reverse split is announced.

How Does a Stock Split Impact Your Portfolio?

When a company notifies its investors about a pending split, the natural reaction for many is to wonder how it will impact their portfolios. Technically speaking, it won’t have any impact at all. Although they’ll likely enjoy the idea of owning so many shares, the feeling is a mirage.

They will still own the same percentage of the company that they did before the split, and their position will be valued at the same dollar amount.

Stock splits often result in a bump in the stock’s price, simply because more investors are interested in the stock at the new price than were interested at the old price. This increased demand can drive up the price of the stock, at least in the short term.

In the longer term, the price will always revert to the intersection of what sellers are willing to accept for a share and what buyers are willing to pay.

The Timing of Stock Splits

There are three dates to be aware of in the event of a stock split:

• Record date: The record date is the date on which you need to be a shareholder of record in order to participate in the split.

• Distribution date: The distribution date is the date you will be notified of the number of shares you now hold as a result of the split.

• Effective date: The effective date — sometimes called the ex-dividend date — is the date the shares begin to trade at the split-adjusted price.

For example, LMNOP Corp. declares a stock split with a record date of March 1, 2022, and a distribution date of March 12, 2022. The effective date of the split is March 15, 2022. So, shareholders who own LMNOP Corp. stock on March 1 will get a letter or email dated March 12 telling them how many shares they now have. On March 15, LMNOP Corp. shares begin trading at the new price.

Before You Split…

Despite the mainstreaming of partial-share investing, several major brokerages and investing platforms — including TD Ameritrade and E-Trade — still require their users to trade only in full shares.

That can make it hard.

Many investors who might want to invest in Tesla, for example, simply can’t afford even a single share with a price tag approaching $1,000 as of Aug. 4 — and Elon Musk knows it. By splitting the stock 3:1, the company lowers the barrier to entry and entices budget investors to put their money into the company without making shares less valuable to existing shareholders.

While splits don’t make companies more valuable, they do represent a window of opportunity. If you’re an investor on a budget whose brokerage doesn’t support partial-share investing, keep an eye out for stock splits in the news. After a split occurs, you just might be able to afford to buy your way into some attractive companies that had previously been out of reach.

Karen Doyle contributed to the reporting for this article.

Information is accurate as of Aug. 4, 2022.

This article originally appeared on GOBankingRates.com: What Is a Stock Split and How Does It Impact Your Portfolio?