Stock Split | Definition

Although a company may be increasing the number of shares outstanding, the company’s market capitalization does not change.

Companies that are traded on public stock exchanges have a share price that any investor, big or small, can purchase. These shares trade at their own price, and the higher the price of these shares, the more difficult it becomes for smaller investors to have a position in these companies. Therefore, as the company wants to ensure that any individual can purchase its shares, the company splits its shares, which increases the number of outstanding shares. 

What is a Stock Split?

A stock split is when a company’s board of directors decides to increase the number of existing shares outstanding. When a company wishes to do a stock split, they make an announcement that tells current and future investors about the change. The report discloses the split ratio, which is the ratio used when the company divides each current share into multiple new shares. Although a company may be increasing the number of shares outstanding, the company’s market capitalization does not change. 

A company's market capitalization is the value of the total number of shares outstanding. For example, if a company has 100 shares outstanding at a stock price of $10 per share, the market capitalization of the company would be $1,000 (100 shares x $10 per share). If the company declares a stock split and states that the split ratio will be two to one, every share outstanding will become two shares, which causes the price of the stock to fall in half. 

Image Credit: AdobeStock

Going back to the example, if the number of shares outstanding was to double and the stock price fell in half, the new values would be 200 shares and $50 per share. When multiplying these values together, the market capitalization value would be $1,000 (200 shares x $50 per share), proving that a stock split does not affect a company’s market capitalization.

Why Do Stock Splits Occur?

As mentioned above, not every investor will have sufficient funds to purchase the more expensive shares. Thus, issuing new shares causes the price per share to decrease, making it more affordable for small investors to obtain equity in the company.  

One recent example that comes to mind is Tesla’s stock split which occurred during August of 2020. The split ratio of the stock split was five to one, and the reason was that Tesla CEO Elon Musk believed the share price was too high, and the high split ratio would allow the price of the share to fall. 

Prior to its five-to-one split, one share of Tesla was worth over $2,000, and as Elon Musk believed the price was too high, he initiated the split. 

Reverse Stock Splits

Sometimes, instead of companies increasing the number of shares outstanding, which would cause their stock price to decrease, they announce a reverse split. They are less likely to happen in today’s markets, but they may occur from time to time. 

Precautions Around Stock Splits

Typically, stock splits benefit stock market investors as it allows them to purchase a higher volume of shares for a lower price or vice versa. However, some companies may use the stock split or reverse stock split to manipulate their financial ratios.

As investors are keen on ensuring their investment has a high probability of returning a profit, they use the financial ratios and statements to evaluate the company’s performance and see whether it is doing well or not. Once they review the financial statements and see a consistent level of growth in the operations, they then move on to the financial ratios to better understand the company’s profitability. 

Image Credit: Shutterstock.com

One of the key ratios used to evaluate a company’s profitability and performance is Earnings per Share (EPS). The EPS formula is equal to the company’s profit divided by the number of shares outstanding, and it is used to determine how much profit is made per share outstanding. There are two things a company can do to make this value higher and more appealing to investors: either increase their profits or lower the number of shares outstanding. 

If a company sees they are struggling to increase their profit levels, it may resort to announcing a reverse stock split to help lower the number of shares outstanding, increasing the EPS value. This will manipulate the value and make investors believe the company’s profitability is much higher than it is. 

Stock splits are a natural part of the stock market, and they typically benefit investors. However, it is one of those things that the company can play around with to try and manipulate specific ratios in their favor to help increase their share price, financial ratios, and overall value of the company. Therefore, when evaluating companies prior to investing in them, it is essential to determine whether they have partaken in a stock split or reverse stock split before. 

Disclaimer: The information above is NOT financial advice. It is only for general information.