What is a stock split and how does it work?

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Amazon, Tesla, Google, Shopify… What do these four huge companies have in common?

They’re all having stock splits this year, 2022.

Cool right?!

Actually, what the heck does that even mean?? A “stock split?”

The term “stock split” has been thrown around a lot this year because so many big companies are doing it.

In this article we’ll discuss what exactly a stock split is and we’ll dive deeper and talk about some disadvantages and advantages you should know.

Alright. Let’s buckle up and get started!

First, what the heck even is a stock split?

A stock split is when a company’s board of directors issues more shares of stock to its current shareholders without diluting the value of their investments.

But more shares doesn’t exactly mean you get more money.

Let’s go over an example to make things clearer.

Amazon recently had a 20-for-1 stock split that went into effect in June 2022.

Before the stock split was initiated, one share of Amazon stock costed around $2,440. Then after the stock split, one share of Amazon costed $122.

So, if you had one share of Amazon before the stock split at $2,440, you would then have 20 shares of Amazon at $122 dollars each (because 2,440 divided by 20 equals about 122). Notice that your total investment still equals $2,440 after the stock split. And the only thing that changed for you is that you now have more shares.

To drive this point home, think of it like this - one big pizza.

Let’s say you bought ¼ of an entire pizza. Then the official board of pizzas decides to do a 4-to-1 split.

This does NOT mean you’re going to get 4 additional slices of pizza. I know I got excited for a second too.

But instead, this means the ¼ of the pizza pie you currently own would get divided by 4.

You still have the same amount of pizza you did before.

But now, your slices are a bit smaller and you have more of them. And because the whole pizza has smaller slices, more people can join in and grab a slice. Making the demand for the pizza even greater.

This leads us to our next topic - the reason for stock splits.

Let’s talk about why a company would want to split their stocks.

There are two main reasons a company would choose to undergo a stock split.

Affordability and liquidity.

In many cases, a stock split is a strategy used by companies to become more attractive and attainable for a larger number of people. As you can see with what happened to Amazon, the cost per share became more affordable to the average investor after the stock split.

As for liquidity, higher liquidity is indicates that a stock is likely to keep its value when its traded, so it’s usually in a company’s best interest to maintain high liquidity.

And as we said, a stock is more likely to be bought and sold if the price is low.

If a stock price costs a couple thousand dollars to buy and sell, then it is less likely to be traded.

So, a company can maintain liquidity for their stocks is they performs a stock split when the price is too high for the average investor.

Now that we understand stock splits, it’s also important that we go over reverse stock splits as well.

A reverse stock split is literally the opposite the process we discussed. Reverse stock splits reduces a company’s number of shares outstanding rather than increasing the number of shares.

If you owned 20 shares of a stock in a company, for example, and the board announced a 1-for-2 stock split, you’d end up with 10 shares of stock.

If the initial 20 shares were valued at $6 per share before the reverse split, the now 10 shares would be valued at $12 per share after the reverse split.

And the total value of your investment remains $120 just like it would with a “regular” stock split like we discussed.

Now let’s talk about some advantages and disadvantages of a stock split starting with advantages.

Stock splits generally happen when the stock price of a company has risen so high that it becomes difficult for new investors to purchase shares.

In other words, a stock split is often the result of growth and it indicates positive performance from a company.

And like we said before, if the price of a stock is split, it will likely attract new investors, causing a small increase in the stock price because of the increase in demand.

So overall, stock splits are a good thing for investors.

Because if you’re already invested in the company, then that means the company is performing well.

And if you’re not yet invested in the company yet, then prices are now more affordable and you can grab a share too.