Stock splits have been making a lot of headlines in the investing world recently. Amazon (AMZN), Google (GOOG 1.27%), Tesla, (TSLA 2.44%), and Shopify (SHOP 2.60%) are just a few of the major names that have announced them in 2022.
Research from the Journal of Banking and Finance shows that stock splits historically have had a positive impact on short-term returns. So should you get excited about companies that are splitting their stock? I believe there's one reason to be optimistic about these events, but another serious reason to approach them with caution.
What is a stock split?
First, let's define what a stock split is and why a company might want to perform one.
As a company's share price goes up, eventually it may reach a level where average investors will struggle to afford even a single share. Amazon, for example, was recently trading above $2,000 before it underwent a 20-to-1 stock split, reducing its share price to around $100. Shareholders were given 19 additional shares for every one they owned, and the value of those shares was reduced proportionally, leaving the company's market cap unchanged.
Lower share prices put those stocks more easily in reach of retail investors. One of the main goals of stock splits is to boost liquidity, under the theory that a more reasonable price will entice more investors to buy the stock.
Stock splits can indicate a company is firing on all cylinders
Let's be 100% clear: A stock split should not be the reason you invest in any company. This financial maneuver does absolutely nothing to improve the long-term performance of a business.
That said, I like to see a company undergo a stock split because on most occasions, it follows a considerable share price rise, and thus typically indicates the company has probably been performing quite well.
For example, since Amazon's last split in 1999, its stock price has risen by more than 3,000%. When a stock rises by that magnitude over 23 years, it's usually because the underlying business has been executing incredibly.
Alphabet -- the parent company of Google -- split its stock in 2014, and rose nearly 300% since then to over $2,000 per share. That prompted its 20-to-1 split this month.
Look out for companies taking advantage of stock split mania
Sometimes struggling companies try to leverage the investor excitement that stock splits generate to boost their share prices. For example, consider GameStop's (GME -1.81%) recent 4-to-1 split.
The niche retailer's stock price oscillations made headlines in 2020 as retail investors conducted a short squeeze that sent its share price soaring. Other short squeeze attempts followed, but since it peaked in January 2021, the meme stock is down by more than 60%.
It's possible GameStop management's motivation for the recent split was to attract more retail traders in hopes of sparking another squeeze. Or maybe the low share price of around $30 will confuse investors into thinking it's undervalued. But the important thing to remember is absolutely nothing has changed about GameStop's struggling business. Its financials are still a mess, and its valuation remains quite pricey at a price-to-book ratio of 7.5.
Investors should be on the lookout when struggling businesses try to capitalize on stock split mania to boost their share prices. It's usually a trap.
Remember the pizza analogy
The easiest way to think about stock splits is to imagine a pizza. No matter how many slices you cut the pie into, the overall amount of pizza remains the same size.
It's the same with companies. You can divide the stock as much as you'd like, but the market cap does not change. Neither do the underlying business's fundamentals.
While it's nice to see your portfolio's big winners split their shares, ultimately, you would be better off focusing on the quality of the underlying business when making investment decisions.