What is a stock split and why do they happen?

Apple has recently announced they will be undertaking a stock split. In this article we discuss the definitions and the reasons behind this.

What is a stock split?

Stock Splits can come in many ratios but the most common is a 2 for 1 stock split. These corporate actions occur when the board of directors decide to increase the amount of shares outstanding.  If a company had 50 million shares outstanding prior to the split, the corporate action will increase the amount of shares outstanding to 100 million shares. The stock price will halve in this 2 for 1 split so the value of the position for the shareholder is unchanged. The company’s market cap is also unaffected. If the company was trading on a price of $100 before the split with the market capitalisation of $5,000,000,000 (50,000,000 shares * $100) then after the split the market cap stays the same of $5,000,000,000 but the share price is lowered to $50 per share ie (100,0000,000 shares * $50). Hence each existing investor will be holding twice as much stock/units but the share price will be halved.

Why do companies participate in stock splits?

When a company believes their stock price is becoming too high and unattainable for the average investor to buy then they may participate in a stock split. The lower stock price will make the stock more accessible to a wilder group of investors.

Apple is planning on a four for one split which will begin trading on the 31 Aug 2020 in an attempt to lower the stock price. Apple shares are currently trading at US$437.50 (as of 11 Aug 20) which may be too expensive for the average retail investor to buy. If they lower this stock price to about $100, it will be more affordable to more investors.

Lowering the share price can also add liquidity to the stock with more buyers and sellers in the market. This can decrease the spread between the bid and offer which will make it more difficult for investors to influence the stock price.

Stock splits can also drive up share prices.  By making the stock price appear cheaper it can drive demand for the stock up as more investors can afford the stock and this in effect can increase the stock price. A stock looks more attractive to many people as $100 per share as oppose to $400 per share.

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What happens to the investors value of the stock?

The value of stocks for investors should stay the same after the stock split. The number of shareholdings will increase according the stock split but the share price will be reduced as well so the net effect is zero. Their shareholding is not diluted as the company has kept the market capitalization the same.

Lauren Hua is a private client adviser at Fairmont Equities.

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