Making Sense of Stock Splits

On Monday, August 2, General Electric Co. (GE) will undergo a reverse stock split. Shareholders will see the number of shares they hold reduced by a margin of 1:8. Post-split, each share of General Electric will be worth the equivalent of eight pre-split shares (adjusted, of course, for changes in market value).

Last week, Nvidia Corp. (NVDA) did the opposite. Its stock split increased the number of shares by a margin of 4:1. The action made each post-split share worth the equivalent of one-quarter of a pre-split share (again, adjusted for changes in the market value of the company).

Stock splits are often misunderstood. It’s not uncommon to see a stock rise following the announcement of a split. This happens even though nothing fundamental with the company changes because of the split and each shareholder’s ownership interest will remain the same post-split. Yet because there can be reactions to splits in a stock’s price, I’m going to share the following primer on stock splits by my colleague Wayne Thorp.

Why Do Companies Engage in Stock Splits?

When a company’s share price increases to levels that it believes are too high, it may decide to do a stock split. The reason for this is that a stock split can make shares seem more affordable to small investors (even though the underlying value of the company has not changed). This also has the practical effect of increasing liquidity in the stock.

When a stock splits, it can also result in a share price increase—even though there may be a decrease immediately after the stock split. Small investors may perceive the stock as being more affordable and buy the stock. This effectively boosts demand for the stock and drives up prices.

Another possible reason for a price increase is that a stock split provides a signal to the market that the company’s share price has been increasing; people may assume this growth will continue in the future, thereby further boosting demand and prices.

Stock Split Dates

When a company announces a stock split, it gives out two dates that are important to shareholders, a record date and an ex-date. You must hold the stock at the close of business on the record date to be eligible for the split, while the actual split itself and the adjustment to the number of shares in your account take place on the ex-date.

Last year, Apple Inc. (AAPL) announced a 4-for-1 stock split. Each Apple shareholder of record at the close of business on August 24, 2020, received three additional shares for every share held on the record date (August 24), and trading began on a split-adjusted basis on August 31, 2020.

If you held shares of Apple before the market open on August 31, you owned four shares for every share you held (1 × 4.0) after the split. The stock price was reduced to one-quarter of its value at the start of trading on August 31. Apple shares closed on August 28 at $499.24 (pre-split), which translated into a split-adjusted price of $124.81 ($499.24 ÷ 4.0). On August 31, Apple shares closed at $129.04.

If you sold Apple shares after the record date (August 24) but before the open on August 31, you sold them at the pre-split price. You were not entitled to the split shares. If you bought Apple shares after the record date but before August 31, you purchased shares at the pre-split price. Following the split, you received the additional shares resulting from the stock split.

What Is a Reverse Split?

Another version of a stock split is called a reverse split. Companies with low share prices typically use this procedure to increase their prices. A company may do this if it is afraid that its shares are going to be delisted or as a way of gaining more respectability in the market. Many stock exchanges will delist stocks if they fall below a specific price per share.

For example, in a reverse 1-for-5 split, 10 million outstanding shares at $0.50 each would now become two million shares outstanding [10 million × (1 ÷ 5)] at $2.50 per share [$0.50 ÷ (1 ÷ 5)]. In both cases, the company’s market capitalization (share price multiplied by the number of shares outstanding) is $5 million.

In May 2011, Citigroup Inc. (C) reverse split its shares 1-for-10 to reduce its share volatility and discourage trading by speculators. The reverse split increased its share price from $4.52 to $45.12 post-split. Every 10 shares held by an investor were replaced with one share. While the split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares, the market cap of the company stayed the same (at approximately $131 billion).

What Should Investors Do?

When it comes to stock splits, this is perhaps the most straightforward question to answer, because most of the time investors should do nothing at all.

You may want to reconsider a stock you own if it undergoes a reverse split, as it often encourages more selling after the action. But with a regular split, there isn’t much more to do besides standing pat. Historically, there is a good chance that immediately following both the announcement and the ex-date, the stock will get a small boost, so if you were thinking of selling just before an announcement, you might want to hold off a little before doing so.