Stock splits tend to get a lot of attention in the news. They can be fun and create a lot of buzz around a stock. But why do companies do them? Are they beneficial to investors?
They can be. ... Well, actually it's a mixed answer. Stock splits usually happen because a stock price keeps rising. That's a good thing! However, the fundamental impact of stock splits and how they might impact your investing strategy isn't what you may think.
You can't control stock splits, but here is what you can do about them.
Why do companies split their stock?
Stocks look like little symbols on a TV or smartphone screen that go up or down, but they're much more than that. Stocks are little pieces of real businesses; a stock represents ownership of a company, and shares are tiny units of that ownership. So, if company XYZ has 100 shares outstanding and you have one, you would own 1/100 shares or one percent of the company.
While share prices can go up or down for many reasons in the short term, a company's share price increases over time as the business makes more money. Sometimes, a company grows so much that the share price becomes too big for some investors to buy full shares. Someone with a smaller portfolio may struggle to accumulate a stock when shares cost $1,500 each.
So, to alleviate this problem, a company can split its stock and lower the share price.
To be clear, the need for stock splits has been reduced in recent years by the growing acceptance of fractional shares among brokerages. Being able to buy a partial share of an expensive stock has allowed retail investors to invest in stocks they otherwise couldn't afford.
Another reason sometimes cited by companies for splitting their stock is related to the stock-based compensation they provide to employees. As share prices get larger, it gets more unwieldy and complicated to issue shares (or options) as compensation. For some employees, it can feel less like compensation when they get 0.12 shares of a stock for a job well done rather than getting 12 shares of a stock. It sounds odd, but some companies take their employees' feelings into consideration.
What happens in a stock split?
Suppose company XYZ trades at $1,500 per share, like in the above example. Management decides to initiate a 10-for-1 stock split. By doing this, the company splits each share into 10 equal parts. In other words, one share worth $1,500 will turn into 10 shares worth $150.
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The most important takeaway about stock splits is that they lower the price of shares but not the company's total market capitalization. Imagine having one pizza but several hungry friends you need to share it with. Everyone gets a slice whether you cut the pizza into eight slices or into 16 slices, but the size of the overall pizza doesn't change. The only real change is the number of slices available to share and the size of each individual slice.
A stock split just divides the whole up into smaller amounts. Share prices are lower, and each share represents a smaller piece of the company's ownership and profits.
Should stock splits impact your investing strategy?
Stock splits do have some purpose; they tend to make accumulating shares easier for individual investors. They are also a good sign because a split means the company grew enough over time to need one. Increasing the number of shares could even help price stability because more shares are available for buyers and sellers.
Despite those potential benefits, you shouldn't buy or sell a stock solely because of a stock split. Remember, you're not getting cheaper shares, only smaller pieces of the business you invest in. Instead, look at fundamental information about a company, like how it's growing, its financial health, and its prospects.
The next time you see a stock split announced, it might benefit you to dig into why that company initiated a split in the first place. There might be good things happening underneath the surface that begin to outline your next compelling investment idea.
