What Is a Stock Split?
Sep 16, 2022
5 min read
In 2020, Apple and Tesla split their shares and now, in 2022, Google have already split their shares and Tesla intend to do so for the second time.
But what is a stock split? How does it work? And why would a company want to split their stock? In this article, we will address these questions and also explain what a share consolidation and reverse stock split are!
Table of Contents
What Is a Stock Split?
So, what is a stock split?
A stock split is when a company decides to increase the number of its outstanding shares. They do this by picking a ratio, such as 2:1, and then increase all existing shareholders’ positions by this ratio.
So, for example, in a 2:1 stock split, all existing shareholders will receive one additional share for every share they owned before the split – i.e. one share becomes two.
At the same time as increasing the number of outstanding shares, the share price is also divided by the same ratio, so the company’s market capitalisation remains unchanged as does the value of each individual investor’s shareholding.
Why Do Companies Split Stock?
The main reason for a company to split their stock is to increase their stock’s liquidity.
Liquidity is important as it determines how easily and efficiently market participants can buy and sell shares. It is essentially a reflection of how many transactions are taking place for a specific type of asset, in this case, a company’s shares.
A low level of liquidity makes it more difficult for buyers to find sellers and vice versa, and also means that larger orders can have an outsized impact on share price. On the other hand, higher liquidity is associated with lower risk and lower spreads and allows traders to exchange an asset more easily.
Another reason for splitting stock is when share price becomes too high. An expensive share price is often unattractive to new investors. A stock split lowers share price and can, therefore, encourage new investors to purchase stock at a more affordable price.
Whilst these newly split, cheaper shares are less valuable than the previous, more expensive ones – there is a certain mentality, particularly amongst retail investors, that would prefer to spend $1,000 on 10 shares, than $1,000 on one share – even if it amounts to the same percentage of the company.
Therefore, this can result in an increase in demand from new investors, at least that is certainty what the company is hoping for. Potentially adding to this effect is the fact that a stock split is viewed by many as a bullish signal. They usually only take place when a company’s stock price becomes too high, which indicates that they are performing well and, consequently, a split is sometimes viewed by investors as a buy signal.
Remember, a stock split in itself should have no effect on the overall market value of the company and each shareholders’ position. However, due to this potential increase in demand from new investors, stock splits sometimes result in a bump in share price.
Google Stock Split Example
One of the most recent examples of a stock split is Google, who split their stock by a ratio of 20:1 on the 18 July 2022.
When the market closed on Friday 15 July, Google shares were priced at around $2,200 per share. However, on Monday morning, Google shares opened the session at around $110 and existing shareholders had twenty times the amount of shares they had the week before. Consequently, Google’s market capitalisation remained the same as before, $1.5 trillion.
In the chart below, the date on which the Google stock split took place is highlighted by a vertical red line.
What Is Share Consolidation?
A share consolidation, or reverse stock split, is the opposite of a stock split.
Instead of simultaneously increasing the number of outstanding shares and reducing the share price, during a share consolidation, a company reduces the number of outstanding shares and simultaneously increases share price by the same ratio.
Therefore, in exchange for their existing shares, shareholders receive fewer, more expensive shares.
We know that company’s split their stock in order to increase liquidity and, hopefully, make what was an expensive stock more attractive to budget-conscious investors. But a reverse stock split means that the company is potentially reducing liquidity and increasing share price. Why would they want to do that?
Why Do a Share Consolidation?
Although, as with stock splits, a share consolidation may seem like an odd decision, there are a few valid reasons as to why a company would want to perform a reverse stock split.
Firstly, many stock exchanges have rules regarding minimum share price. If a stock falls below this threshold, they risk being delisted from the stock exchange in question.
Naturally, for a public company, this would present a big problem and negatively affect their ability to attract investment. So, in order to avoid delisting, companies which find themselves in this unenviable position will often undertake a reverse stock split in order to boost share price and remain on the exchange.
Secondly, stocks which trade at low values, particularly so-called penny stocks, are often associated with higher risk and are viewed in a negative light by many investors. In an attempt to escape this negative image, companies may choose to perform a share consolidation to boost share price and attempt to restore some investor confidence.