In 2022 alone, three of the biggest and richest tech companies in the world — Alphabet Inc. (the parent company of Google), Amazon and Tesla — all announced plans for stock splits, and the very announcement of the upcoming splits caused their stock prices to jump. The day after Alphabet said it would be split its shares Feb. 1, 2022, for example, the company's stock surged 7.5 percent.
So what is it about a stock split that gets investors excited? And what kind of a message is a company trying to send by dividing their shares 2-for-1, 3-for-1 or even 20-for-1? We spoke with Derek Klock, a finance professor at Virginia Tech about the psychology of a stock split.
What Is a Stock Split?
Unlike a lot of financial terminology, this one is fairly easy to grasp. A stock split is when a company decides to take all its outstanding shares and divide them up by a certain number, whether that number is two, three, five or 20. The total value of the shares doesn't change, just the number of shares in circulation and their individual price.
Think of it like making change. If you have a $20 bill and exchange it for two $10s, the total value hasn't changed ($20) but now you have twice as many bills, each worth one-half of the original bill. Now, say you exchanged that $20 bill for 20 singles, that's a 20-for-1 split. The total value is still $20, but each bill is worth one-twentieth of the original.
Stock splits work the same way. Let's say Company XYZ has 1,000 outstanding shares, each trading at a price of $1,000 per share. That means Company XYZ has a market capitalization of $1,000,000. If Company XYZ issues a 2-for-1 stock split, there are now 2,000 outstanding shares each with a share price of $500.
"A stock split doesn't change the market capitalization of the company," Klock says. "It simply changes the number of shares outstanding."
After the stock split, the total value of Company XYZ is still $1,000,000 (2,000 shares x $500), but there are twice as many shares in circulation. So if you own 10 shares in Company XYZ valued at $10,000, after the 2-1 split, you'll have 20 shares still valued at $10,000. That's because the stock price "splits," too, from $1,000 to $500, so there's essentially no economic value change.
The decision to split a stock is made by a company's board of directors and requires approval by the U.S. Securities and Exchange Commission (SEC).
Why Do Companies Split Their Stocks?
Historically, companies issue stock splits when their stock price gets too high. But isn't a high stock price a good thing, since it shows that the stock is in high demand? Yes and no. A rising stock price is a sign of investor confidence in a company's future profitability, but if a stock price gets too high, then regular investors can get priced out.
Think of it like this. If the hot holiday toy costs $30 instead of $300, then a lot more people can afford to buy it. If a company wants to attract more investors, especially new investors, then it will want to keep its share price within a "favorable range," Klock says. For an investor with limited funds, a $50 share in a hot company is less of a risk than a $500 share.
And to be fair, it seems to work. When Apple issued a 4-for-1 stock split in 2020, retail investors flocked to buy shares. Retail investors are non-professional investors, i.e., folks like you and me. When Apple made each share four times cheaper, retail investors went from buying $150 million in Apple shares each week to buying nearly $1 billion a week.
Stock Splits as a Psychological 'Signal'
For Klock, though, the conventional rationale for why companies issue stock splits is outmoded. In the past, stocks were traded by brokerage firms in bundles of 100, and a high stock price really did put the stock out of reach of all but the wealthy and institutional investors.
But Klock says that the investment landscape completely changed with the advent of online trading — where anyone can buy and sell stocks online for low fees. Not only can retail investors buy individual shares (instead of bundles of 100), but online brokers like Schwab, Fidelity and Robinhood allow investors to buy stock "slices," which are fractions of a share.
At Robinhood, for example, you can buy "fractional shares" that are as tiny as a millionth of a share, making investments affordable at any stock price.
So if lowering share prices to a more "favorable" range is not as much of a driver anymore, then why do companies like Alphabet, Amazon and Tesla still issue stock splits? Klock says that announcing a stock split is primarily a way for a company to send "an open positive signal" to the market that it expects its stock price to keep going up.
"In my opinion, [the decision to issue a stock split] is almost entirely psychological versus any kind of real financial rationale behind it," Klock says.
What Stock Splits Mean to Regular Investors
So the question is, what are regular investors supposed to make of this "signal"? If you own a stock that's about to split, should you hold it? And if you're thinking about investing in a company, does a split really tell you anything about its financial health?
As Klock explains, a stock split doesn't tell investors anything concrete about a company's earnings or profitability; that type of information is released in quarterly earnings reports. But a stock split is a reliable sign that the people inside the company, who presumably know better than anyone about the company's future performance, think that things are only going to get better.
As far as returns on investment, the "positive signal" of a stock split seems to prove correct. Nasdaq conducted research in 2019 that looked at all of the major stock splits from 2012 to 2018. It found that simply announcing a stock split resulted in an average boost of 2.5 percent to a stock, and split stocks outperformed the rest of the market by almost 5 percent after one year.
So if you already own a stock that's about to split, the data indicates that the stock price will likely experience an immediate bump. And if you're considering investing in a stock that just split, there's strong evidence that the investment will pay off. Then again, nothing in investment is a sure thing, so consult a financial adviser before making any decisions.