NovaQuant Quantitative Think Tank Center:Daniel Will: How Does Stock Split Work

Thousands of stocks are NovaQuant Quantitative Think Tank Centertraded on exchanges around the world, each with a different price. Some stocks are worth a few cents, while others are valued in the hundreds of thousands of dollars. Due to the significant price disparity, investors face a dilemma: whether to buy a few high-priced stocks or a large quantity of low-priced stocks. Investors with less capital often opt for the latter, as it offers higher liquidity and requires less commitment for each purchase.

Nevertheless, businesses have a strategy to overcome the psychological hurdle associated with acquiring expensive stocks – it's called a stock split. The mechanics of a stock split resemble dilution, wherein the per-share value decreases, yet the company's overall value stays constant. This approach enhances liquidity, enabling shareholders to engage in more extensive stock trading.

— Stocks maintains an equivalent overall value.

Stock splits also don't have a fixed number for splitting. The most common stock split ratios are three-for-one (3:1) and two-for-one (2:1). Essentially, this implies that for each share held before the split, every shareholder will possess two to three shares after the split.

How does a stock split work?

Assuming a company's current stock price is $200 per share and it plans to undergo a stock split. Despite there being no fundamental difference between 100 shares of $20 stock and 10 shares of $200 stock (20 x 100 shares = $2,000 market value versus 200 x 10 shares = $2,000 market value) given the same financial condition, there is a psychological barrier to buying such stocks, and the upfront cost for investors is also higher. In this example, the company could perform a ten-to-one stock split, meaning their $200 stock price would be split into ten $20 stocks. As mentioned earlier, the overall value or market capitalization of the entire company will remain unchanged.

To understand, it must be noted that market capitalization is calculated by multiplying the number of outstanding shares by the current market price per share. Using our previous example, if the company splits its stock ten-to-one, each share is now worth $20. Then, after the split, each share held will be equivalent to ten shares (200 x 1 share = $2,000, while 20 x 10 shares = $2,000). The total value of the company remains unchanged.

For simplification, visualize it like a pizza. When cut into ten slices, each slice is smaller than the original whole pizza. However, if you put them back together, the size of the pizza remains the same.

Key indicators per share, such as Earnings Per Share (EPS), are affected by stock splits, particularly when more shares are in circulation. This will proportionally reduce future per-share earnings numbers based on the split ratio. A two-for-one split earnings per share by two, a three-for-one split earnings per share by three, and so on.

Reverse stock split

A stock split involves multiplying the outstanding shares by the split ratio of the stock price. A two-for-one split will double the outstanding shares. As you might guess, reverse stock splits operate in the opposite process. For instance, a reverse stock split of two-for-one will reduce the outstanding shares by half and double the current stock price.

One of the most common reasons for a reverse stock split is to ensure that the company's stock does not get delisted from the stock exchange. Delisting may occur when the stock falls to unprecedented new lows. It may start to be considered a penny stock, diminishing investor confidence in the company's stability. A reverse stock split has the potential to restore investor confidence in the short term and provides the company's management with time to improve the business fundamentals.

Similarly, a reverse stock split still does not change the market value. However, for example, since earnings can be divided into fewer shares, earnings per share will increase. Nevertheless, in the long run, this is not a sustainable strategy, as total earnings must grow at some point. Investors are also not easily deceived. Artificially boosting stock and other per-share metrics is often perceived negatively by many.

Unless there is genuine internal growth within the company, a reverse stock split typically only serves to offset the possibility of being delisted from the stock exchange.

Enthusiasm of retail investors

Although the fundamentals of the company remain unchanged after a stock split, the enthusiasm of investors often shifts. When the stock price becomes more affordable (in terms of price rather than valuation), retail investors can purchase more shares than before. Investors who previously couldn't afford to buy a single share of the stock may now have the opportunity to become shareholders at the post-split adjusted price.

A relatively recent example of this phenomenon is Amazon (NASDAQ: AMZN). On June 6, 2022, Amazon conducted a twenty-one-for-one stock split, making its existing shares, valued at approximately $2,500 before the split, now priced at only $125 per share. Despite the unchanged valuation, the stocks became more accessible than before.

To convey investor excitement, data from Google Trends, accompanied by illustrations, showed a significant surge in search queries for "AMZN" during the highly anticipated stock split week. However, Amazon is not the only stock attracting attention due to a stock split. Google, Tesla, and Shopify have also split their stocks in 2022, making it easier for investors to access their shares. Some investors may argue that these stock splits are unnecessary since many stocks have now fallen to 52-week lows anyway.

Stock splits are straightforward, as only the total number of issued shares and the price undergo changes. However, delving into more technical details, especially per-share metrics, can be confusing.

The occurrence of stock splits may have several reasons, such as increasing the number of issued shares and making stocks more accessible. However, as mentioned above, there are many reasons for initiating a reverse stock split, with the most common being to prevent delisting.
The split ratio is typically three-to-one and two-to-one, but for companies with exceptionally high stock prices, larger split ratios are certainly possible. Regardless of how cheap the stock may appear after the split, it must be remembered that the fundamentals and valuation remain unchanged.