In a stock split, each existing share within a company is divided into multiple additional shares. Consequently, a company’s share count increases while the price of one single share decreases in proportion to the number the stock is split into.
For instance, after a 3 to 1 stock split, investors would own three times as many shares as before since each existing share would be divided into three shares. While stock splits may seem like a superficial corporate action at first glance, they have become conventional for most companies in recent decades in order to keep share prices at a certain level.
Some regard stock splits as essential for companies while others will find stock splits meaningless and unnecessary. In the following, we will go through some of the pros and cons regarding both the perspective of investors and companies when a business decides to conduct a stock split.
Advantages of Stock Splits
1. Stock Splits Increase Liquidity
Stock splits increase the total amount of outstanding shares by a substantial number, while the company’s market capitalization stays the same. When a company with 20 million shares is suddenly split up into 60 million shares after a stock split, the price of an existing share inevitably decreases to a more affordable level.
Low stock prices might encourage smaller investors to get into and trade the stock more often than it would be the case for higher prices. Traders may also take advantage of lower share prices to execute frequent trades that inevitably increase a stock’s demand and result in an active market.
Stock liquidity decreases the spread between the bid and ask prices and can be beneficial to investors who need to open and close their position quickly whenever they need to. Liquidity is generally favorable because it allows for high transparency and stability of stock prices.
2. Stock Splits Prevent Too High Prices
At the stock market, there is usually seems to be a certain range of stock price levels at which major companies will trade, while only some stocks (such as BRK-A) trade at exceptionally high price points. Part of the reason for that is the fact that most companies want to allow investors to buy into the company at reasonable price entries.
Apple (AAPL), for instance, decided to split its stock at 4 for 1 in August 2020 as the stock price previously climbed the $500 per share mark. Now the company is trading at affordable levels to a broader range of investors at around $150 per share.
The firm already split its stock a few times before. If the company hadn’t decided to go the stock splitting route, the stock would now trade at very high prices and most likely be not as liquid and frequently traded as it is today.
3. They Allow Companies to Send Positive Signals
One incentive for companies to split their stock would be to signalize to investors, how confident the management is standing towards the company’s future.
Studies have shown that there is usually a small price increase following a company’s announcement to opt for a stock split, suggesting that one reason for the positive market reaction can be the rise in demand as a result of the bright message which the company sends out with the announcement of a planned stock split.
Disadvantages of Stock Splits
1. They Don’t Change Fundamentals
Stock splits don’t affect the fundamentals and therefore the value of a company. In that aspect, they can essentially be considered meaningless. Suppose that you have a cake and decide to cut the cake into multiple pieces. Regardless of the number of pieces you cut the pieces into, the size of the cake won’t change nor will the cake itself taste any different than before. Essentially, you will still have the same cake in front of you.
Financial analysts and investors will still find a share of stock trading at $200 per share expensive when they decided that it was overvalued at $600 per share before the stock split in the first place as the value of each share has decreased proportionally.
Companies don’t become more valuable after a stock split, simply because nothing has changed within the companies fundamental characteristics which raises the question of whether companies would really need to conduct stock splits in the fashion that they do today.
2. Stock Splits Cost Money
The process for a company to conduct a stock split from the announcement to the execution involves time and money. In the most usual cases, a company hires a bank to plan and execute a stock split which will then charge a fee. That fee might not be too considerably high relative to the company’s size but can be viewed purely as a cosmetic cost that could have been used for other purposes instead.
3. They May Attract the Wrong Type of Investor
Warren Buffett isn’t only known for his unprecedented investing success but also as the CEO and chairman of Berkshire Hathaway, one of the most valuable companies by market capitalization in the world. One unique characteristic of Berkshire’s stock is that its Class A shares are by far the most expensive stock in the world trading at a whopping $420.000 per share.
Clearly, not everyone would be able to buy class A shares because of that prestigious price per share. But why exactly has Warren Buffett decided to not split the stock a single time in its history of decades?
In Berkshire’s letter to shareholders of 1984, Buffett wrote that he isn’t intending to split Berkshire’s stock.
The primary reasoning behind Buffett’s intention is that he views his shareholders as partners who are committed to the long-term success and performance of the company. As a consequence, he would rather prefer long-term partners instead of day-to-day investors that buy and sell the stock in short periods just like any other stock.
If the company agreed to split the BRK-A shares multiple times in the company’s history, they would now trade at affordable prices entries that could have allowed any investor and trader to get in and out of the company.
The high price of class A shares at which they trade today will make most investors think through their investment thoroughly before they decide to invest in the company.
The Bottom Line
While stock splits don’t affect the fundamental value of a company, they certainly can have notable effects on how investors perceive the price of a given stock.
As a result, some strong arguments speak for stock splits not only as a cosmetic tradition for most major companies but also as a strategic long-term decision to increase stock liquidity and how a business may want to be perceived and by investors and shareholders.