I will never understand the excitement of stock splits. It's just taking the same-sized pie and cutting it into smaller pieces. There is a hidden value to stock splits that benefits some traders, but the long-term picture remains the same.
Image source: Getty Images.
What is a stock split?
A stock split is when a company increases the total number of shares in a non-dilutive manner. If a company doubles its total shares outstanding, its stock price will simultaneously be cut in half.
Suppose an investor's 10 shares of a company are revalued at $500 each. This results in a $5,000 position. If the company announces a 10-for-1 stock split, that same investor will have 100 shares valued at $50 apiece.
That math does not change your $5,000 position. Some investors may react to the stock split, which can result in some added volatility, but in the long run, you own the same percentage of shares as you did prior to the split.
For most people, a stock split serves as an ego boost. It allows the investor in this example to say they own 500 shares of a company instead of 50 shares.
Why companies do stock splits
If stock splits do not change a company's intrinsic value, then it's easy to wonder why companies actually follow through with this practice. However, some effects change the stock that do not reflect in the fundamentals.
First, the stock will become more affordable on a per-share basis. A $500 stock is worth only $50 per share after it goes through a 10-for-1 stock split. Before the split, an investor could have easily bought fractional shares, but most people prefer to own full shares of the companies they buy.
Reducing the stock price via splits accounts for the psychological factor that investors want a larger number of shares when investing in companies.
Stock splits also helped tech giants Alphabet (GOOG +1.53%) (GOOGL +1.77%) and Amazon (AMZN +1.94%) become eligible for the Dow Jones, which is a price-weighted index. If both companies were still valued at thousands of dollars per share, they would have too much influence on the Dow Jones.
Most companies aren't doing stock splits to join the Dow Jones, since that benchmark has only 30 companies. The more widely cherished S&P 500 index weights companies by their market cap, so stock price doesn't matter as much.
Lower stock prices increase trading activity
The psychological effect of a lower stock price can attract more retail investors and boost trading volume. More importantly, it makes options trading more viable.
The prices of call and put options are based on the underlying stock's price, and traders cannot buy fractional options. If a stock is worth $500 and a call option with a specific price and expiration date is worth $30, then that same call option for 100 shares will be worth only $3 if a stock split brings the price down to $50 per share.
Increased trading activity does not guarantee that a stock will gain value, but it ensures more volatility. That results in sharper price movements in either direction. Bullish rallies can gain momentum, while bearish reversals can be a bit sharper post-split.
Ultimately, investors must tune out the noise of a stock split and assess a company's fundamentals and long-term catalysts. If those two details get you excited, it may be worth holding on to the stock. However, a stock split won't be enough to revitalize a company that is losing market share, has a troubling balance sheet, and misses out on catalysts.
