What is a Stock Split?

All industries are guilty of using confusing jargon, and the world of investing is no different. This week, we find out what a stock split is, and how it could affact you as an investor.

We’re on a mission to end the glut of investing jargon. And for good reason.

Talking to our customers, we hear plenty of reasons why they have never invested before. Some are fearful of losing their life savings. Others believe that the market is nothing more than a playground for the white-collar elite.

However, the most frequently cited reason for not investing is a basic lack of understanding about how the whole thing works.

This is due, in part, to the language of investing. Order types, short-selling, compound interest and economic moats. Sometimes, it seems as though it’s specifically designed to scare people away.

At Rubicoin, we want to make investing enjoyable and understandable. To do this, we plan demystify some of the most frequently used terms in investing that can confuse people.

This week, we’re looking at stock splits.

Stock Split

A stock split is exactly what it sounds like – the splitting of stocks.

When a company initiates a stock split, it simply divides all of its shares into smaller parts.

 

This means that two things will happen – the number of shares available will go up, and the price of each individual share will go down.

However, the most important thing to remember is that – although the number and price of each individual share will change – any money you have already invested in the company will not change. No real value is added or subtracted to your investment in a stock split.

Imagine a company that had 500 shares at $20 each. If this company was to implement a 2-for-1 stock split, they would split every share they have into two – giving them 1,000 shares overall.

But because each share was split, the value of each share is split too. So in this instance, because there are now 1,000 shares instead of 500, each share will only be worth $10 instead of $20.

Some people might assume that because the value of each share has been halved, this means that they’ve lost half their money. Thankfully, this isn’t the case.

Again, the amount of money you have already invested will never be altered by a stock split. Instead, you’re just getting more shares that are worth less.

So if you had invested $100 dollars into this company, you would have owned 5 shares worth $20 each before the split.

stock-split-explained

After the split, you will still have your $100 investment – but it will be in the form of 10 shares worth $10 each.

Stock-Split

Why Split Stock?

So if a stock split doesn’t actually affect the fundamental value of an investment, what’s the point?

Well, there are a few reasons why companies will go to the bother of a stock split.

  1. A stock split is most often used by companies who believe their stock price has become too high. A company like Priceline, for example, can seem inaccessible to most investors because just one share will cost in the region of $1750. To fix this, Priceline’s board of directors might decide to implement a 3-for-1 stock split. This would mean that the price of a single share in the company is reduced down to about $580 – a much more reasonable price per share.
  2. Leading on from this, some companies will implement a stock split to increase a stock’s liquidity. Liquidity is the degree to which a share can be quickly bought or sold in the market without affecting the asset’s price. Highly priced stocks are less liquid because of their expense, while cheaper stocks are more likely to be bought and sold. Companies will generally want more liquidity because it means that their stocks can be sold easier without compromising their value. A stock split is one way to achieve this.
  3. Finally, and perhaps most tenuously, is the belief that stock splits are used by companies for publicity and to increase interest amongst investors. Of course, this could certainly be achieved through a lessened share price in some much-sought-after companies, but it’s unlikely that a stock split would garner much more publicity than that… unless it’s a very slow news day.

Split Adjusted

When you’re examining the past performance of a company, you might see that its charts have been ‘split-adjusted’.

If a company has had stock splits in its past, simply comparing historical share prices with the current share price would not be accurate. The true level of how much a share has appreciated over time will not be factored in.

So let’s go back to our hypothetical company for a minute.

Let’s say they started trading at $5 a share back in 2000. Over the next ten years, their share price grows to $20 a share. At this point, they decide to do a 2-for-1 split. This sends their share price down to just $10, while the number of stocks available doubles.

So now you can buy a single share for just $10. But the company keeps on growing, and in 2020, hits $20 per share again. So they have another 2-for-1 stock split and the share price goes back to $10.

We can see the company has been doing pretty well for itself. But if you were to just compare the historical and current share prices, you could mistakenly think that the value has only grown from $5 to $10 over a 20-year period – which isn’t accurate.

To remedy this, we use a split-adjusted analysis instead. This means that we factor in each stock split to give a true idea of the company’s growth.

So for our hypothetical company, the charts won’t show a drop in share price thanks to the stock splits of 2010 and 2020. Instead, the past share prices will be adjusted accordingly to the current price. This will show that the share price in our company actually grew 8-fold to value of $40.

So how does a stock split affect investors?

In short, not very much.

There is generally very little hype surrounding a stock split. This is because the most important consideration for any investor – the level of equity invested – isn’t directly affected by a stock split.

Whether you have 10 shares in a company for $10 each or 5 shares for $20, it doesn’t really matter. Both equate to a $100 investment, and it’s the growth (or decline) of that figure which is of primary concern to you as an investor.

In truth, the most important thing about a stock split is knowing what they are, especially in terms of split-adjusted charts. That was, you can get a better feel for the company, and understand the past growth of a company a lot better.

 

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2 responses to “What is a Stock Split?

  1. Typo!

    “thanks to the stock splits of 2010 and 2010″

    *”thanks to the stock splits of 2010 and 2020”

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