Investors just love stock splits. While a company's market capitalization typically offers more important information than its stock price, a four-figure price tag on a single share can intimidate most investors. However, thanks to stock splits, a top stock like Amazon (AMZN 3.43%) looks a lot more attractive at $145 a share today.
Let's dig a little deeper and see whether or not stock splits actually make any difference to a stock, and what you should do about them.
What are stock splits anyway?
Stock splits are corporate events through which a company increases the number of its outstanding shares by splitting its existing shares by a factor greater than one. In other words, the pie stays the same size, but now there're more pieces, with each piece being smaller than it was previously. While stock splits often double the number of outstanding shares, they can be in any ratio.
For example, when Amazon conducted a 20-for-1 stock split about a year and a half ago, it gave its stockholders 20 shares for each share they already owned. Prior to the split, Amazon stock sported a price tag of more than $2,000 per share, while after the split, each share was worth about $100.
Shopify (SHOP 1.11%) split its stock around the same time with a 10-for-1 split, and each share that was worth about $350 became worth $35.
Image source: Getty Images.
In general, significant stock gains indicate high-quality underlying businesses. So while the split itself may be immaterial to the immediate value of the company, a stock split eventually entices more investors to buy up its shares as they now seem more "affordable" on a per-share basis. This action drives the stock price higher, and in turn, the company's overall value.
In short, stock splits signal market participants that these are top stocks and could be valuable candidates for equity portfolios.
Stock prices and valuation
But despite the theatrics, don't confuse price and valuation. Not all companies are the same, and their stock prices reflect their size, performance, and opportunity. That's why investors often use valuation ratios like price-to-earnings, price-to-sales, or price-to-free cash flow as measures of how expensive or cheap a stock is, rather than its absolute dollar value. A high price tag can come with a low valuation and vice versa, so a stock trading for $10 with a price-to-sales ratio of 20 can be more expensive than a stock trading for $100 with a price-to-sales ratio of 2. When a stock splits, its valuation doesn't change.
How to play the stock split
Companies usually announce their stock splits several months before they happen. Sometimes the lag is so long that other things happen in the meantime and the split never happens. Most of the time they do occur as planned, and investors have plenty of time to consider whether to buy before or after a split, if at all.
As mentioned previously, conventional thinking is that stock prices rise after a split, and so it makes sense to load up on the stock before the split happens. There is some evidence to back that claim, but the rise is often quick and temporary. Stock splits don't actually affect the stock or company in the long run -- they just make the stock seem more accessible. If the stock has excellent fundamentals, it's likely to gain in the long term, but that reflects the company's fundamental capabilities and opportunities.
Let's consider how some of the recent stock-split stocks have performed, and how they fared relative to the overall market. In addition to Amazon and Shopify, other recent high-profile stock splits include Alphabet (NASDAQ: GOOG), Nvidia (NASDAQ: NVDA), and Tesla (NASDAQ: TSLA).
All these stocks have soundly outperformed the S&P 500 over the past year. However, this information is somewhat misleading as it pertains to their stocks splitting.
As a group, these stocks uniformly underperformed the market in 2022, with the exception of Nvidia, when investors moved out of tech stocks. In the second half of last year, after their splits, they still mostly underwhelmed.
Their performance over the past year says more about the market's attitude toward tech stocks than about how the splits affected the stock price. It also demonstrates why it's so important to target excellent stocks and then hold them for the long term. All these stocks have made up their 2022 losses and gone on to gain more this year.
Focus on what's important
In most cases, investors can buy shares of companies with a high price tag through fractional shares. A great example now would be MercadoLibre (MELI 3.09%). MercadoLibre stock trades at a price of more than $1,600 per share, and management hasn't made any move to split it. It's a top stock to buy, but investors who don't have that much to invest in one shot are not priced out. If you invest with fractional shares, you get a piece of the share, which gains or loses accordingly.
Investors shouldn't give too much weight to stock splits, but you can use them to identify stocks worth looking into. You should always investigate the underlying value of any stock, paying closer attention to valuation than price, and use that information to make a considered decision.
