Stock Split is an important event for most of the corporates as it gives them the flexibility to manage the stock price of their company. Theoretically stock split should not have any impact on the overall market value of the company but it has been proven time and again that it can have a huge psychological impact on the investors’ mind and in a way can have significant value to the company.
So, it is no surprise when Apple (AAPL) and Tesla (TSLA) announced a split of 4:1 and 5:1 respectively, rallied the two shares to new highs. But what is specifically is a stock split and why should you care when they happen?
What is Stock Split?
Stock split is a process to increase the total shares outstanding for a company, however, the total market cap of the company remains the same. The stock split requires the explicit approval of the board of directors and the number of shares after the split goes up by the split ratio. At the same time, the market price of the stock is reduced by proportionate amount.
We can compare the stock split to a pizza slice where a whole pizza (stock) is divided into pizza slices (split stocks). Let us assume the price of Pizza is $10 and it is split into 4 pieces, indicating a price of $2.5 per slice. Similarly, a stock with a market price of $100 after split into 4 pieces would have a market price of $25. So, if an individual did have 10 stocks earlier, she would have 40 stocks not, but the overall value of the stock would still remain the same i.e. $1000.
The above image depicts the stock split of Apple from its inception till 2005. The stock split happened in 2:1 ratio in 1987, 2000 and 2005. Ideally the stock price should have been reduced from 100 USD to 12.5 USD and each stock would split to 8 stocks.
Is stock split Good for Investors and the company?
We cannot generalize to indicate whether a stock split is good or bad, rather it is the market condition that dictates the efficacy of the stock split. Also, it is the individual company and its outlook that is a crucial factor as well. For good companies where the stock price has reached a stage where it has gone out of reach for retail traders, a stock split helps in bringing the stock price down and in turn helping the stock more accessible by the retail traders.
So, if the market value of a company does not change why does companies go for stock split? Also, if the effective stock price does not change why should investors be excited about the stock split?
Keep stock price in comfortable zone:
The first and foremost reason for most companies to go for stock split is that, it allows companies to keep stock price in comfortable zone.
Companies like Apple has split its stock 5 times in the last 33 years. If Apple would not have split its stock since inception and the stock price would have increased as per the historical trend, then each of the stock would have been at close to $20,000 today. This would have made it extremely difficult for the retail investors to buy/trade the stock.
Recently Tesla has split its stock and it has a market price of approximately 400 USD now compared to the pre-split price of approximately 2000 USD.
Play with Investor Psychology
It is common investor psychology that keeps them away from selecting a stock whose market prices is too high. Many investors usually associate higher stock price with expensive stock and do not consider the intrinsic value of the stock.
Having a lower stock price plays with the psychology of investors and some of them may consider the stock to be cheap even though it might be much more expensive compared to a high-priced stock. Instead of comparing the stock price with the book value or the EPS of the company many investors compare the price with the stock price of another company.
Have more volatility and effective price discovery
A quality stock which has lower market price is traded more frequently. Many retail investors will be able to trade a stock which has smaller market price. Also, we usually see a big run up after the announcement of the stock split and typically after the actual stock split the stock price goes down.
As the famous saying in the market, “Buy on Rumour and Sell on news”, similarly the stock price goes up with the announcement of the stock split and typically goes down for some time after the actual splitting of the stock.
We can observe this trend in case of Tesla, where the stock started the rally from 11th Aug 2020 (when the stock split was announced) and continued till 31st Aug (when the actual stock split happened). This trend can also be visible in case of Apple and many other quality stock that has gone for a stock split in recent years.
We can say that even though the stock split does not have any significant impact theoretically on a stock but for some of the quality stocks it can have good psychological impact on the investors which can help the stock reach new highs.
If you’re interested in learning more about the market, you can read our previous article on Patterns and Trends