Understanding Stock Splits

stock market Oct 23, 2020
Understanding Stock Splits

In this article, we will talk about the stock market splits. Many of you probably heard this term, many others are hearing it for the first time. When you hear the term “stock split” most of the time the most common association would be “speculation” and “gambling”. 

Before we get into details, we will explain what kind of splits there are. There are two types of stock splits — conventional and reverse. Most people only know the conventional, while the reverse is completely unknown. Let’s take a look at the diagram below

Both splits have a purpose and it is not some random gambling opportunity for us as investors to gain easy money. When most investors hear that there will be a stock split (conventional) they associate this event as a cheaper entry to buy the stock they wanted, but couldn’t afford. For example, we can take the recent Apple split. On the 28th of August, Apple did a 4:1 split. Meaning that for every share you own, you would get 4 shares (conventional split). Before the split, Apple’s market price was $499.23 (1 share). After the split, the market price dropped to $124.81. So basically if you had 1 share pre-split, now you own 4 shares at $124.81.

Looking at the price difference you would think it’s way cheaper and a good price to buy, but is it really cheaper? The answer is “No”. In the previous article, we talked about market cap. Do you remember when we talked about the market price per share? 

Let’s theoretically say Apple’s market cap is $1000 and the price per share is $500. At that price, you would own 2 shares. Now let’s make a 1:4 conventional split. Market cap will still be $1000, though now after the split you would own 8 shares. Looking at the numbers you would say to yourself “ 2 shares before, 8 now after the split. I made a good choice. 

Though in reality, you made a pretty poor choice. Why? In both situations the market cap is $1000, the only difference is the number of shares. If the market cap remains the same, it does not matter how much shares you own after the split. The shares will cost exactly the same as before the split, you will just own more shares because the market cap remained unchanged. So instead of buying cheap, you would still buy it at the same price. The only difference is the number of shares. Conventional splits are a very cheap trick for uneducated people to get the “offer” without realizing what they are buying. Conventional splits are used to increase the total outstanding shares, thus providing more availability to a wider range of investors and raising more funds for the company doing the split.

The second type of split is the reverse split. This type of split is mostly used by companies whose shares decline significantly. Exchanges have a list of requirements, which must be fulfilled by the company in order to get listed on the exchange. One of the requirements is the minimal price per share. If the company’s price per share declines significantly and is near the minimal price per share, the company must take action in order to prevent delisting. To prevent that, the company would make a reverse market split. The reverse split is the complete opposite of the conventional split. Let’s say Apple has 1000 total outstanding shares and a total market cap of $1000. This means the price per share is $1. Let’s say you own 200 shares, while the market cap remains $1000. If Apple does a 4:1 reverse split you would own 50 shares at a price of $4 per share. If you look at this split, it is exactly like the conventional. You won’t lose or gain anything from the split. The only thing that will change is the number of shares that you own. Though the purpose behind this split is to increase the price per share of the stock by reducing the total outstanding shares, this kind of split could temporarily save the company from being delisted and provide some time for the company’s management to fix their issues. If the company’s management does not manage to fix the issues and get the investors' trust back, it could possibly face another split or in the end, go bankrupt.

After reading this I hope you have a better understanding of stock splits and why they’re not some random events that give you “cheap” opportunities. Why are they not “cheap” opportunities? Looking back at the recent Apple split, many people thought the price was cheap and bought in. The opposite of what investors expected happened, Apple stock started declining. Be smart and never take anything for granted. There is nothing guaranteed in the financial markets unless you earn it yourself with hard work.

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