Have you noticed that Apple's (AAPL -0.57%) stock is almost always priced somewhere between $100 and $500, and yet the company has consistently delivered tremendous returns for its shareholders over the years?
Why isn't the stock price higher?
This is because Apple has repeatedly split its stock whenever the price ran up beyond a certain price. In a stock split, a company divides existing shares in order to lower the price per share. Imagine a pizza that has been cut into six slices. If you were to cut each slice in half to make 12 slices, the pizza itself wouldn't get any bigger; you'd just have two smaller slices for each original slice.
That's how stock splits work.
The main reason a company would want to split its stock is to make the share price more affordable to everyday investors and, in turn, boost liquidity.
But since we know the stock split itself doesn't change the size of the pizza (i.e., the market capitalization of the company), should you consider buying companies after a recent split?
Here are two reasons to buy stocks after a split and one reason not to.
1. You liked the company before the split was announced
It could, however, be perceived as an indication of a strong company since businesses don't typically split their stock when the share price has been crashing.
But overall, the stock split itself should not be the motivation for the purchase because it doesn't impact the intrinsic value of the company.
For example, if you're considering buying Alphabet (GOOG -0.72%) (GOOGL -0.74%) after its recent 20-for-1 stock split, the reasoning should be that the company has a nearly impenetrable moat due to its strong network effects and dominant brand recognition, or something similar.
You shouldn't buy the stock because you believe the split will somehow make the company stronger in any material way.
There is data to suggest splits can move the stock price upward over the short term, but for long-term investors, this shouldn't be viewed as a reason for buying.
2. You've done your research
The main issue with using stock splits as a catalyst for buying is it may lead you to buy a stock you've done little to no research on.
Stock research ought to be the foundation of your conviction, so if you're considering buying a stock after a split announcement, be sure you've done your homework.
For example, investors may be tempted to buy GameStop (GME -0.47%) after its recent 4-for-1 split. But if you're basing your purchase on the split alone, you'd be buying a wildly unprofitable company that has seen its stock completely disconnect from the underlying business due to its reputation as a meme stock.
In simpler terms, if you're buying GameStop because of the recent stock split, you'd be buying an extremely risky asset that appears to be moving mostly on speculation rather than business execution.
The dividing up of shares does not magically improve the prospects of the business, so if you're buying a stock split, make sure you've done adequate research, which has led you to believe the company is a quality business trading at a reasonable price.
Don't buy the stock thinking the split will add long-term value
Let's all say this together: Stock splits have zero impact on the underlying business.
Splits neither improve nor deteriorate the long-term potential returns of stocks. They might drive a short-term movement in the price, but they do not have any material influence over the long term.
Therefore, you should never buy a stock solely because the company announced a split. If you're considering buying a stock before or after a split, make sure you've done your research and developed a solid thesis for why you believe the business will outperform.