Stock Market — Finances — Investing

Debunking the Myths: The Truth About Stock Splits

Are stock splits worth the hype? It’s time to separate fact from fiction. Advantages, disadvantages and impacts on your portfolio: I’ll explain everything to you!

Investiforum

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Do You Like Pies?

The stock split is a concept that can be difficult to understand, but an analogy may be useful to give a better understanding of the concept. A stock split can be compared to dividing a large pie into several smaller pieces.

Imagine that you are at a dessert party. A pie is cut into four equal parts; each piece is therefore quite substantial, and you receive one. Unfortunately, your host decides (for no reason!) to cut each piece a second time in two. The four equal parts are each cut, resulting in eight equal parts, and you end up with two necessarily smaller pieces. However, you quickly understand that it hasn’t changed anything, either for you (you still have the same amount of pie as initially) nor for the pie (its size remains fixed). Sorry if I made you hungry!

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Just as a pie can be cut into several pieces to share it with more people, a company can choose to divide its shares into several smaller pieces to make investing more accessible to small investors.

Say you have a company that has 100 shares outstanding, each worth $100. If the company chooses to do a two for one stock split, it means they will split each stock into two smaller shares. After the split, there will be 200 shares outstanding, each worth $50.

Before the split, you own 1/5 of the company’s capital through 1 share
After the split, you still own 1/5 of the company’s capital, but through 2 shares

The size of the pie does not change, so the value of the business is not changed. Following the split, if you owned one of the original five shares, you now end up with two shares. However, you still own the same proportion of the pie (the same proportion of value), but through a larger number of shares.

You therefore understand that by default, the capitalization of the company, equal to the outstanding shares multiplied by the price per share, is not affected by this split. Indeed, the increase in the number of outstanding shares is offset by an equivalent decrease in the share price.

Advantages of Stock Split

For Companies

A stock split has several advantages for a company. Small stocks are easier for small investors to sell and buy, which can attract more investors to the market and stimulate interest in the company. It can also reduce the cost of buying shares for small investors, which can be a plus for the company in terms of marketing and attracting investors.

Overall, it can improve the liquidity of stocks, because there are more of them in circulation, and therefore it is easier to buy and sell them.

For Investors like You and Me

Stock splitting can also have benefits for retail investors. Firstly, it can make investing more affordable for small investors. For example, if you can’t afford to buy a stock at $100, you might be able to buy 2 stocks at $50 after a stock split. And with the development of consumer brokerage platforms like Robinhood, it is not excluded to now observe crowd effects, especially in the event of splitting. Indeed, in this case, the action then becomes much more accessible for the greatest world.

Photo by Papaioannou Kostas on Unsplash

Secondly, it can also increase the value of the long-term investment, as a company that does a stock split may be considered stronger and in better financial health.

Indeed, splits are often seen as a positive signal sent by company management, because companies tend to split their shares only when they believe that their fundamental outlook is strong. A point that will interest more than one investor, both private and institutional.

Disadvantages of Stock Split

Stock splits can also have some disadvantages that you should be aware of. First, it can possibly lead to a decrease in the value of the share in the short term. That remains possible, but unlikely, in my opinion. However I can admit that a $100 stock divided into two $50 stocks may seem less attractive to some investors. Investor’s psychology is such a thing!

It can also affect stock performance, because since the split does not change the fundamentals or the profit of the company, the latter will be distributed among more stocks and therefore each stock will earn less. However, this disadvantage is offset if you have benefited from the split: whether you earn $2 per share while having one share, or $1 per share while having two shares, it is basically the same.

Myths About the Stock Split

As I said, a stock split increases the number of shares for all shareholders. By doing so, there is no change in anyone’s right to vote. For example, if you owned 1% of the company before the split, after the split you would certainly have twice as many shares, but then there would be twice as many shares outstanding. So you would still own 1% of the company. It’s mathematics.

In addition, there is no relevant impact on the dividend side. Since the dividend yield is expressed as a percentage of the price per share, 1% remains 1%; whether you own 1 share at $1000 or 10 shares at $100, you will receive $10 in dividends in both cases.

Finally, stock splits have no impact on company fundamentals or valuation. Because they drive the stock price down, valuation multiples will not be directly affected.

A Final Word

Basically, nothing changes for you in a stock split. When companies perform stock splits, they simply reduce the cost of action and therefore the barrier to entry for retail investors.

Photo by Adeolu Eletu on Unsplash

This type of event is considered very positive for the company, because it is a signal of good financial health.

I’m Raphaël, founder and editor-in-chief of Investiforum.fr, a financial website for French-speaking private investors. Thanks for reading! Don’t hesitate to follow me on Medium, Twitter or Polywork.

This article is for educational and entertainment purposes only and shouldn’t be considered as financial or legal advice. Not all information will be accurate, but all the data is sourced. Consult a professional before making any significant financial decisions. This article shouldn’t be seen as an incentive to buy or sell any of the securities mentioned therein, nor endorsement to any presented strategy. Some links can be affiliated ones.

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Investiforum

Blogger at investiforum.fr (investing for french investors). I talk about investing, financials & money with a long term mindset.