Stock splits explained: What They Are, How They Work, and Case Studies
Ever heard the term 'stock split' and wondered what it's all about?
Picture this: your favorite pizza joint suddenly decides to cut each slice in half, doubling the number of slices but maintaining the total size of the pie. That's essentially what happens in a stock split!
Read on to find out how a stock split works, why companies choose to split stock and learn about Nvidia's June 2024 recent stock split.
What is a stock split
A stock split is a corporate action where a company divides its existing shares into multiple new shares to boost liquidity and accessibility.
For example, in a 2-for-1 split, each existing share is split into two, halving the price per share but doubling the number of shares held by each shareholder. The overall value of the investment remains unchanged, but the reduced share price makes the stock more affordable and attractive to small investors. Companies often perform splits to maintain an optimal trading range and enhance marketability.
Example: NVIDIA stock split
In May 2024, NVIDIA (NVDA) reported its quarterly earnings and announced a 10-for-1 stock split of NVIDIA's issued common stock. The company said this was to make stock ownership more accessible to employees and investors. This split resulted in lowering Nvidia's share price but it didn't affect investors' total value of their Nvidia holdings.
Every individual holding common stock at the market's close on Thursday, June 6, 2024, was entitled to receive nine extra shares of common stock. Distribution took place after the market closed on Friday, June 7, 2024, and trading recommenced on a split-adjusted basis the following Monday, June 10, 2024.
In the years leading up to the split, NVIDIA experienced strong growth and market performance, which the company largely attributed to innovative technology and strategic partnerships. This stock split, Nvidia's second one in its history, signaled a positive outlook, increased liquidity, and strong market demand, making its shares more accessible to a broader range of investors.
How a stock split works
A stock split works by increasing the number of shares outstanding while reducing the price per share proportionally, ensuring the company's market capitalization remains the same.
This process enhances share liquidity and accessibility, making the stock more appealing to a broader range of investors without altering the company's overall value.
In the example of Nvidia, there's also a psychological component with the stock split. Under its 10-for-1 split, each existing Nvidia share is divided into 10 shares. If Nvidia's stock was priced at $1,000 before the split, it would be $100 after.
Shareholders see their number of shares increase, but the total value of their holdings remains unchanged. The shares may now appear more attractive. An investor may likely prefer to buy 10 shares Nvidia at $100 vs. 1 share at $1,000.
What is a 2-for-1 share split
A 2-for-1 share split is where a company decides to issue a stock split where every share it has is divided into two. This means that each share is now worth half of its previous price, and there is now double the number of shares of this company.
Investors who already hold the stock within their portfolio will see the price of each of their shares halved, but the number of shares they own will double. In other words, this means that the worth of their total share holdings in the company remains unchanged.
Why do companies split stock
Companies split shares to enhance liquidity, making their stock more accessible and attractive to a broader range of investors. By lowering the share price through a split, the stock becomes more affordable for small investors, potentially increasing trading volume.
This increased liquidity can lead to narrower bid-ask spreads and more efficient pricing. Companies may use splits to signal confidence in future growth, positively influencing investor perception.
Additionally, a stock split can indirectly impact a stock's inclusion in an index, such as Dow Jones Industrial Average (DJIA) or an exchange by potentially meeting eligibility criteria. In the case of Nvidia, its $1,000 share price, it automatically excludes them from the price-weighted DJIA as high-priced shares alter the index. Its new lower price may provide a future opportunity for inclusion. Just ask Amazon.
Overall, share splits help maintain an optimal trading range, fostering greater marketability and broadening the shareholder base.
How does a stock split affect investors
A stock split affects investors by increasing the number of shares they own while reducing the price per share proportionally, leaving the total value of their holdings unchanged.
For example, in a 2-for-1 split, an investor with 100 shares priced at $50 each will end up with 200 shares priced at $25 each. This can make the stock more affordable and potentially more attractive to new investors, enhancing market liquidity.
While the value of an investor's investment within their portfolio doesn't change, the perceived affordability from the price of shares being halved and their holdings doubled, can lead to increased demand and trading activity.
Pros and cons of stock splits
Pros
Increased liquidity: More shares at a lower price can make the stock more affordable and attractive to a broader range of investors, potentially increasing trading volume.
Positive market perception: A stock split can signal confidence from the company’s management in its future growth, often leading to a positive market response.
Improved accessibility: Lower per-share prices can make the stock more accessible to small investors who might have been deterred by higher prices.
Cons
No fundamental change: A stock split does not alter the company’s fundamentals, market value, or shareholders' equity, which means it doesn’t provide any real economic benefit.
Temporary price volatility: The split can cause short-term price volatility as the market adjusts to the new share price.
Increased administrative costs: Implementing a stock split involves administrative tasks and costs, including updating records and communicating with shareholders.
Stock split vs. reverse stock split
A stock split increases the number of shares while reducing the price per share proportionally, maintaining the same overall market value. For example, in Nvidia's 10-for-1 split, an investor owning 1 share at $1,000 each becomes 10 shares at $100 each, enhancing liquidity and accessibility.
Conversely, a reverse stock split consolidates shares, increasing the price per share proportionally while reducing the number of shares. For example, in a 1-for-2 reverse split, 200 shares at $25 each become 100 shares at $50 each. Companies do a reverse stock split to increase the stock price, which can help maintain exchange listing requirements, improve the stock's marketability, and attract institutional investors who may have minimum price criteria for investments.
What happens to fractional shares in a stock split?
You may be wondering — what happens to my fractional shares in this situation?
As we know, when a stock undergoes a stock split, you receive more shares while the price per share decreases proportionally. This remains the same when we are dealing with fractional share trading. For example, if you own 3.5 shares of Stock Y priced at $15 each, and Stock Y has a 2 for 1 (2:1) split, you'll now own 7 shares at $7.50 each.
Conversely, in a reverse stock split, your shares decrease and any fractional shares are usually compensated with cash. For instance, if you own 5.5 shares of Stock Z valued at $10 each, and Stock Z undergoes a 1 for 2 (1:2) reverse split, you'll end up with 2.5 shares. Typically, you'd receive cash for the 0.5 fractional share, equivalent to $5.
