How Does a Stock Split Work and Why Is It So Important?

Thousands of stocks trade on exchanges worldwide, all varying in price. Some shares are worth pennies, while others are worth hundreds of thousands. Because of these massive deviations in price, investors are faced with a dilemma; to purchase a couple of high-priced shares or large sums of lower-priced ones. Investors with less capital will typically choose the latter, given there's more liquidity and less commitment to each purchase.

However, there is a way for corporations to mitigate the psychological barrier to purchasing higher-priced stocks. This is known as a stock split. Stock splits work similarly to dilution—each share is worth less, but the underlying company value remains constant. In doing so, there is increased liquidity as shareholders can trade a higher volume of shares—of the same collective value. There's no set number into which a stock splits either. The most common ratios for stock splits are three-for-one (3:1) and two-for-one (2:1). Simply, this means that for every share held before the split, each stockholder will have two or three shares, respectively, after the split.

How Does a Stock Split Work?

Suppose a company's recent stock price is $200 per share, and plans to issue a stock split. Despite there being no fundamental difference between a company's 100 shares of $20 stock versus 10 shares of $200 stock ($20x100shares= $2,000 capitalization vs. $200x10 shares = $2,000 capitalization)—given the financials are the same—there is a psychological barrier and a larger upfront cost to the investor to purchase such a stock. In this example, the company could issue a ten-for-one stock split, meaning their $200 share price would be divided into ten $20 pieces. As mentioned, the value of the whole company, or market capitalization, would remain unchanged.

To understand, it must be noted that market capitalization is calculated by the number of shares outstanding multiplied by the current market price per share. Using our previous example, the company split its stock ten-for-one, and each share is now worth $20. Then every share held will equal ten shares after the split ($200x1share=$2000 vs. $20x10 shares=$2000). The total value of the company remains the same.

To simplify, visualize a pizza. When divided into ten pieces, each piece is smaller than the original uncut pie. But if added back together, the pizza size remains constant.

Per-share metrics, such as earnings-per-share (EPS), will be affected by stock splits given there are more shares in circulation. This would decrease future EPS figures in proportion to the ratio of the split. A two-for-one would divide EPS by two, a three-for-one would divide EPS by three, and so on.

Reverse Stock Splits

A stock split multiplies the outstanding shares by the ratio at which the share price was divided. A one-for-two would increase the shares outstanding by a factor of two. A reverse stock split—as you might guess—works in a reversed process. For example, a one-for-two reverse stock split would decrease the shares outstanding by two and increase the current share price by twofold.

One of the most common reasons for a reverse stock split to occur is to ensure a company's stock won't be delisted from an exchange. Delisting can occur when a stock falls to unprecedented new lows. It may begin to be viewed as a penny stock, which makes investors less confident in the company's stability. A reverse stock split could potentially revive investor confidence for a short period, and provide time for the company's management to improve the business fundamentals.

Similarly, reverse stock splits still don't change market capitalization. However, EPS, for instance, would increase since there are fewer shares to divide earnings into. However, this isn't a sustainable tactic over the long term because total earnings will have to grow at some point. Investors aren't easily deceived either. Boosting the stock—and other per-share metrics—artificially is generally perceived negatively by many.

Unless true growth is observed within the company, a reverse stock split generally only wards off the possibility of being exiled from an exchange.

Retail Investor Enthusiasm

While the fundamentals of a company don't change after a stock split, investor enthusiasm usually does. When a share price becomes cheaper—in terms of price, not valuation—retail investors can purchase a higher quantity of shares than before. Investors which previously couldn't afford a single share of the stock may now have the opportunity to become a shareholder at the split-adjusted price.

A relatively recent example of this phenomenon is Amazon (NASDAQ: AMZN). On June 6, 2022, Amazon issued a twenty-for-one stock split which made its existing shares, approximately worth $2,500 before the split, worth only $125 each. Even though the valuation remained constant, the shares become more accessible than before.

To help convey the excitement from investors, data from Google Trends illustrates a massive spike of search queries for "AMZN" on the week of the highly-anticipated stock split. However, Amazon isn't the only stock that garnered attention from a stock split. Google, Tesla, and Shopify all split their stock in 2022 and made their shares more accessible to investors. Some investors could argue these stock splits were redundant, given many stocks are now falling to 52-week lows anyways.

Closing Thoughts

Stock splits are straightforward since only the total shares outstanding and the price is meant to change. However, it's easy to get confused when looking at more technical details, particularly per-share metrics.

A stock split can occur for a couple of reasons—to increase outstanding shares and make shares more accessible—but there are a variety of reasons to initiate a reverse stock split as highlighted, most commonly to prevent delisting.

Split ratios are most commonly three-for-one and two-for-one, but larger split ratios are certainly in the realm of possibility for companies with extraordinarily high share prices. Regardless of how cheap the stock may appear after a split, it must be remembered that the fundamentals and valuation remain the same.

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