We have received many questions from investors over the past several years on stock splits and how these events impact their investments. In particular, companies often do share splits in conjunction with an IPO and the discrepancy with the post-split IPO price and the pre-split investment price can create confusion. Today, we will shed a little light on this topic and explain what stock splits are, why they are used and—the most critical part from an investment standpoint—why they don’t impact returns.
What is a stock split?
A stock split is an action taken by a company’s board that changes the number of shares outstanding. Splits can happen in two forms. The most common is a plain vanilla split which increases total shares outstanding. For example, a 10:1 (10-for-one) split will mean that each share held by investors splits into 10. If the company had 100 shares outstanding previously, they now have 1,000. A reverse split is exactly the opposite. In a 1:2 (1-for-two) split, every two shares held by investors are converted to one share. Here, if the company had 100 shares outstanding previously, they now have 50. What happens if you only had one share outstanding prior to the reverse split? Likely, you won’t own ½ a share post-split. Companies tend to not issue fractional shares, so you will probably receive cash payment in lieu of shares.
Why do companies split and reverse split shares?
The primary motivation is typically a trading liquidity argument. Some practitioners believe that there are optimal share price ranges
that support trading liquidity. As an extreme example, take Berkshire Hathaway A shares (BRK-A). At the time of this writing, they were trading at over $300,000/share. That is not the easiest entry point for most people to make. Even for investors that can afford the hefty price tag, it could create portfolio diversification issues. A share split to a more bite-sized double- or even triple-digit stock price may thus create an environment where more investors can and are willing to trade. For this reason, companies often split shares if they see a significant increase in their share prices. Apple (AAPL) did so several times (most recently in 2014) -- fun fact, we estimate that split-adjusted price for AAPL shares (assuming no splits) would be nearly $10,000 versus the high $170 price tag today.
Another common scenario that we see is companies splitting right before an IPO. Both traditional and reverse splits are used in these cases. Why? Again, probably trading liquidity. From our observations, companies seem to like to start out on the public stage with share prices in the ~$10-30 range. Depending on the company’s funding history, they may elect to do a stock split to get there.
What impact do share splits have on investment returns?
None. There is no direct impact whatsoever. Long story short here: the aggregate value of your shares is still worth the same pre- and post-split. Keep in mind that two things change in a split from an investor standpoint (1) the number of shares you own and (2) the price per share. The movement in (1), however, offsets the movement in (2) so you end up in the same spot.
Yes! Think of a company like a pizza.
Imagine you and 15 of your friends order a pizza for dinner (16 total) and split the bill. This particular pizza will be cut tavern style
(i.e. square/rectangular pieces), because your humble EquityZen analyst here is from the Midwest and that’s what we do there (also, it was easier to draw). And our pizza is a rectangle. Work with me here…(rest assured East Coasters, you can still fold your rectangle pizza and it’s still not ok to use a knife and fork).
Back to the matter at hand…
The pizza arrives cut in 16 equal slices. Before you dive into your slice, though, you decide to step over to the kitchen to select a refreshing can of pop
to go with your dinner. While you are away, someone decides to cut each existing slice of pizza into two pieces. Why? Unclear, but now the pizza is cut into 32 equal slices.
How has this action by your friend changed your pizza eating plans? It hasn’t. Remember that you paid for 1/16 of the pizza. Because there are now 32 slices of pizza, you will eat two pieces (32÷16=2). These two pieces, though, were cut from the original one piece that you would have consumed if your friend had left the pizza well enough alone. You get two smaller pieces versus one larger piece. The total amount is still the same.
The same is true for companies. Say you own 20,000 shares of a company—lets call it SplitCo—that has 100,000 total shares outstanding. The share price is $10. SplitCo does a 2:1 split. Post-split, SplitCo will have 200,000 total shares outstanding, but each of these shares will now be worth $5. Pre-split you owned 20,000 shares at $10 each. Post-split, you will own 40,000 shares at $5 per share. Your total investment has not changed.
Why don’t share splits impact returns?
The key here is that a split has no impact on the total size of a company. Thus, just like in our pizza example, if you create more shares, you are just splitting a pie into more pieces. You don’t get any more or less pie.
So what does change the size of the pie? In the case of corporate finance: valuation. For the sake of simplicity, you can think of a company’s valuation as being driven by two dimensions, similar to the area of our rectangular pizza. While the pizza’s size is determined by length and width, a company’s valuation will be determined by a fundamental metric (e.g. revenue) and a multiple (like P/S). Anything that impacts either of those two dimensions will change the size of the pie that everyone has to share. A larger pie equals positive returns, a smaller pie equals negative returns. If you purchased 1/16th of a 24”x24” pizza and the delivery person showed up with a 28”x24” pizza instead, you have a pizza gain. Similarly, if you purchase a 1/16th share of a company whose valuation increases from $1m to $2m, you have an investment gain.
Head still spinning?
Another way to think about this is...
- A company’s valuation is determined by fundamentals and market conditions, e.g. revenue and a P/S multiple.
- Shares outstanding are determined by a company’s board.
- The share price is a byproduct of the valuation and shares outstanding (i.e. share price = valuation ÷ shares outstanding).
- Look at the formula above (#3). Assume no valuation considerations from (#1) change and only shares outstanding change (this is what happens in a stock split). If the share count goes up, the share price will decrease by a proportionate amount. If the share count goes down, the share price will increase by a proportionate amount.
- Following this (#4), your investment (the number of shares you own multiplied by the price) will not change in a split.
Is there anything else I should know?
Yes, a few items:
- We have noted repeatedly throughout this post that stock splits do not have a direct impact on returns. All financial theory (and math) supports this claim. There has been some research conducted on whether there may be indirect impacts on returns following a split — e.g. whether greater trading liquidity could potentially increase valuation. To our knowledge, no one has quantified this impact in a reliable way and the impact (if any) is unlikely a meaningful driver of returns.
- Splits should NOT be confused with dilution. In the case of dilution, an increase in shares outstanding CAN impact your returns. Let’s go back to our pizza. In a dilution scenario, your friends would invite two additional people to the party. For the sake of simplicity, let’s say these new invitees don’t pay for pizza, but still expect to receive a share. You have paid for 1/16th of the pizza, but you will receive less than that given that you now have to share with two additional people. Similarly, with companies, dilution happens when new shareholders come on board at more favorable economics than prior shareholders. We will explore this more in a subsequent blog post.
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