Growing up as an overweight child I would constantly be thinking about food. My mother’s method of food control was telling me that I could only have one SLEEVE of cookies at night. I used to think she was crazy, I mean only one sleeve! One summer in high school I made some major lifestyle changes and lost over 40 pounds. While my waistline certainly changed, I still constantly think about food. I just have a bit more self-control these days. I like to focus these thoughts about food into analogies to help me understand certain concepts. In today’s article, I’m going to be explaining how a stock split is just like cutting a nice, hot pizza with ALL the toppings. (Currently drooling)
Why do stock-splits happen?
If you recall in my article, Making Money in Stocks since the 1600s, I discussed that when a company gets listed on the exchange they issue a certain number of outstanding shares and the price of those shares is determined by supply and demand. Sometimes the prices of shares are driven so high that they become unattractive to the average investor and the company performs a stock-split to get the price to a more reasonable level. A great example with this is Apple stock in 2014. The price per share at that time was roughly $645 dollars. That’s a heavy cost to pay for only 1 share. In June of that year, they performed a 7 for 1 stock split and the share price then changed to roughly $92 dollars a share. Much more reasonable right??
What happens in my account after a stock split?
Here is where our pizza analogy comes into play. When a company performs a stock split they are simply increasing the number of outstanding shares while simultaneously reducing the share price. Because the two occur together, the VALUE of those shares remains the SAME. Think about the outstanding shares of a company being just like a pizza that is cut into 4 slices. When we have a stock split we turn the pizza into more slices but each slice is now a smaller piece. In the end, the size of your pizza is exactly the same, you just have more slices adding up to the whole pie. Make sense?
A typical stock split is 2 for 1 or 3 for 1, but a company can make it whatever they want as we saw with Apple. We can also have what’s known as a “reverse stock-split” This is the exact opposite of the forward split and this occurs when a company’s share price is LOW and they want it to be more attractive by being a higher price. The reverse split will REDUCE the company’s outstanding shares and make the share price higher. Many people are avoidant of stocks under $3 dollars a share because they can be volatile and are considered to be “penny stocks.” For this reason the company decided to do a reverse split to make them more attractive to a larger group of investors.
For example, Pizzeria Incorporated could be trading at $1 dollar a share. The company decides to perform a 1 for 5 reverse split so that its stock will now be trading at $5 dollars a share.
As a stockbroker, I spoke with many clients who had thought they had either made or lost a lot of money very quickly when a split occurred in their account. Others believed that they should buy the stock before the split so they could acquire more shares after it happened. As we saw in our pizza example, the value of your investment does not change. If you had 50 shares of Pizzeria stock at $100 dollars a share and they performed a 2 for 1 stock split you would then have 100 shares at a price of $50 a share. Notice that is the SAME MARKET VALUE.
I believe people get confused because in most cases a stocks price is driven up by demand after the split occurs. Think about it. If something you wanted was really expensive and now the price was cut in half would you want to buy it? Yes! And that’s what the company wants too when they performed the split.
Homework: Take a look at 3 companies that have had stock splits recently and see how it affected the price of the stock in the week following the split. Have you ever held a stock in your account that went through a split? Comment with your experience below.