The stock market is an interesting concept. It is a constant battle between the bears (investors who believe stocks are moving down) and the bulls (those who believe stocks are going up). At first glance, you would think this battle is being waged between investors alone, but the role companies themselves play in this battle may surprise you.
Management teams at publicly traded companies have several tools at their disposal that can be used to tip the scales in the direction of the bulls, bolstering the value of their stock. Not only do these tools impact the way the investing public sees a stock, but they often have a profound impact on the future path of the company.
One such tool in the publicly traded C-suite’s toolbox is known as the stock split. Stock splits happen all the time, either in a traditional sense, or as a reverse split. While, by their nature, stock splits are more about optics than anything, they are great clues as to the stability of a company and investor interest in the stock.
Stock splits hit the limelight in the summer of 2020 when Apple announced a 4-for-1 split and Tesla announced a 5-for-1 split. But what exactly is a stock split and what does it mean for the future of the stock that performs it? Let’s take a closer look.
What Is a Stock Split?
Ultimately, stock splits are cosmetic, changing the number of existing shares without changing the overall value of the company. They offer publicly traded companies a way to either increase their price per share, or reduce their price per share by adjusting the number of outstanding shares of the company.
Think of a publicly traded company as a pie, and each share of stock as a piece of that pie. By increasing the number of pieces within the pie, each individual slice becomes smaller, or less valuable. Conversely, when you cut the pie into fewer pieces, each slice is larger, making it more valuable. A stock split is essentially the decision to carve up the pie differently.
There are two different types of stock splits:
- Forward Stock Split. During a forward stock split, the company increases the number of shares in an attempt to reduce the per-share price of their stock. For example, Apple’s 4-for-1 stock split means that if you owned a share of Apple before the stock split, you now own four shares of Apple stock. However, the transaction itself did not change the total value of Apple. When the split occurred, investors were given four shares for each share owned, but the value of each share under the new structure was divided by four.
- Reverse Stock Split. A reverse split is the polar opposite of a forward stock split. The goal in a reverse stock split is to increase the per-share price of the stock. To do so, multiple shares are combined to make a single, more valuable share. For example, if a stock trades at $0.10 per share and the company performs a 1-for-10 reverse stock split, that means investors would receive one share valued 10 times greater — at $1 per share — for every 10 shares they owned.
Why Do Stock Splits Happen?
Stock splits are not a matter of coincidence. They are planned events that a company’s management and Board of Directors purposefully carries out. But why?
There’s value in a company having the ability to control its stock price. There are very real benefits to increasing or reducing a company’s stock price, without affecting market capitalization, depending on market conditions.
Why Forward Stock Splits Happen
There is only one reason for a forward stock split to happen. Stocks that do extremely well in the market get extremely expensive. Take a look at Amazon (AMZN) — the stock is trading at more $3,000 per share. Before the Apple (AAPL) split, Apple’s share price was around $500 per share. That’s expensive.
According to CNBC’s Make It, the average American has just shy of $9,000 in savings. At the prices above, a single share of Amazon stock would cost one-third of that. A single share of Apple represents a value equal to more than 5% of the average American’s savings.
Knowing that stocks go up and down, would you risk 30% — or even more than 5% — of your total investable assets on a single investment? That’s a huge leap of faith. Those high prices for single shares make these stocks seem unapproachable to many investors — they’re just too expensive.
Publicly traded companies have the ability to solve this problem by splitting stock, adding additional shares to the market and making each individual share smaller, just like Apple did. Following its 4-for-1 split, Apple shares are worth one-quarter of their former price, or around $125 per share. At that price, a one-share investment in Apple would be the equivalent of just over 1% of the average American’s savings. That’s a much smaller pill to swallow, making the average American much more likely to invest in Apple.
Why Reverse Stock Splits Happen
Reverse stock splits are on the other end of the spectrum. The ultimate goal of a reverse stock split is to increase the stock’s price. Also, unlike forward stock splits, there are multiple reasons a publicly traded company might want to increase its price. Some of the most common of these reasons include:
Compliance With Stock Exchange Rules
Major stock exchanges in the United States and around the world have several rules that publicly traded companies must follow in order to maintain their listing. Of course, listing on a major stock exchange is important, as investors have far more access to these stocks, increasing demand — and therefore price — as well as liquidity. Considering that price and liquidity are among the most highly regarded factors of any investment, maintaining listing on a major exchange is important for any publicly traded company.
One rule that most major stock exchanges share is a minimum bid price rule. Although each exchange sets its own minimum bid price, the spirit of the rule is the same across the board. If the company’s share price falls below the minimum bid price for an extended period of time, it is in danger of becoming delisted — being removed from the exchange.
For example, the Nasdaq requires stocks to maintain a minimum bid price of $1. Should a stock fall below the $1 mark for a period of 10 or more consecutive days, the stock will face potential delisting.
A reverse stock split can be performed to stop this from happening. For example, let’s say XYZ stock is trading at $0.80 per share. In order to avoid delisting, the company moves forward with a 1-for-5 reverse split, bringing the post-split price per share to $4, well above the $1 minimum, without affecting the company’s overall market cap. This allows XYZ stock to remain listed on the Nasdaq, offering the company access to investors that only major exchanges can provide.
There is a stigma surrounding low-priced stocks, with the belief that the lower the price of the stock, the younger or more troubled the company must be. As such, many investors — especially institutional investors — follow general rules with regard to price when making their investment decisions. In particular, some investors refuse to invest in stocks that have a price per share of $5 or lower, fearing that these low-priced stocks will come with too much risk.
Sometimes, a company’s Board of Directors will vote to move forward with a reverse stock split to solve this perception problem.
For example, ABC Company currently trades at $2 per share. The CEO at ABC believes that his stock price is being held down because investors fear making an investment in a stock valued at under $5 per share. To solve this problem, ABC’s CEO moves forward with a 1-for-5 reverse stock split.
Upon the completion of the reverse split, ABC is now trading at $10 per share, making the stock break above the key $5 level that makes it palatable to institutional investors, while leaving plenty of room to stay above that mark should the stock experience declines in the future.
Analyst coverage is overwhelmingly valuable for publicly traded companies. Most investors will consider analyst opinions before making investment decisions. Moreover, when a major Wall Street analyst covers a new stock, it’s a big deal, often garnering mainstream news coverage and getting the stock in front of investors who may have never found it before the coverage.
Like investors, most analysts aren’t going to waste their time with stocks that trade in the penny range. There are far too many more established companies for these professionals to spend their time recommending — or advising against, for that matter.
So, a company with a low price stock that believes analysts would have a favorable opinion may move forward with a reverse split for the sole purpose of attracting analysts’ attention. The higher stock price as a result of the reverse split would mean that the company’s stock has the potential to show up on the stock screening results when analysts look for new opportunities to dive into.
What Do Stock Splits Mean for Investors?
Although stock splits are cosmetic moves and therefore have no actual bearing on the underlying value of a stock, the long-term implications of a stock split can be breathtaking. However, because forward splits and reverse splits are complete opposites, the implications of these moves for investors are quite different as well.
What Forward Stock Splits Mean for Investors
Forward stock splits are great for investors, and they know it. In fact, when Apple first announced its 4-for-1 stock split, it was trading at around $400 per share. By the time the split actually took place about a month later, the stock price had grown to nearly $500 per share — a gain of around 25% on the anticipation associated with this “cosmetic” move.
So, why do investors get so excited about stock splits?
It’s a basic economic matter known as supply and demand. As with anything else, when demand for a stock rises, the price of that stock will rise as well. Ultimately, stock splits are moves designed specifically to increase demand for a stock.
The goal of a stock split is to reduce the price of a stock in order to make that stock more accessible to the average investor. Therefore, after a stock split takes place, the expectation is that new investors who formerly would not have purchased shares due to the high price will begin to buy.
This attraction of new investors leads to a sharp increase in demand often lasting for anywhere from a few days to weeks or even months following a stock split. Of course, increased demand is a good thing for investors because it results in higher prices — and, for the pre-split investor, profits!
What Reverse Stock Splits Mean for Investors
On the other hand, reverse stock splits can mean several things for investors, some of them good, and some not so much.
Maintenance of a Major Listing
Remaining listed on the major stock exchange is one of the positive results of a reverse stock split. This is overwhelmingly important because, if the stock were to lose its listing, it would also lose widespread access to investors, leading to a lack of liquidity and decline in value.
Sometimes a reverse stock split can make a stock more appealing for analysts. It doesn’t always attract analyst coverage, but when it does, it’s great news — especially if the analyst shares the investors’ positive opinion of the company.
When an analyst covers a stock, they will provide an investing idea, letting other potential investors know where the analyst believes the stock will go in the next 12 months, as well as their rating, usually on a Buy, Hold, Sell scale. If a reverse split moves the price enough to put a stock on an analyst’s radar, and that analyst rates the stock as a buy with a price target suggesting that it will outpace overall market returns, the stock could see dramatic gains.
The Company Is Struggling
On the other side of the coin, a reverse split is often a red flag. Keep in mind that the vast majority of reverse splits happen with a goal of maintaining a listing on a major stock exchange. Being at risk of delisting in the first place often means that stock has seen a substantial decrease in value, falling deep into the penny stock category. Investing in any stock on a downtrend can be a dangerous proposition.
The bottom line is that if a company is performing a stock split to avoid delisting, three key things have happened:
- The stock price has seen significant losses.
- Organic attempts to increase the share price through corporate activities, increases in sales, and other options have failed.
- The company’s management has decided that the bad optics and negative attention the reverse split will likely generate — which tend to lead to dramatic declines that can cost investors millions of dollars — is less painful than a delisting from a major exchange.
Reverse stock splits are often a sign of financial struggles at publicly traded companies. If the company was financially and operationally sound, the value of the stock would not fall below minimum bid price requirements.
Dilution May Be Ahead
Any time a company is struggling financially, investors are forced to wonder what the company will do to improve its balance sheet. Unfortunately, strategic moves to do so often come at the expense of investors.
For example, a company that can’t make ends meet may move forward with a public offering of common stock. In these transactions, companies issue new shares of common stock in order to repay debts or to sell to raise the capital they need to survive.
The only problem is that what the company is selling in these transactions is a portion of the value that’s already held by current investors. Again, think of a company as a pie, and stock as the pieces of the pie. The pie isn’t getting any bigger — cutting more slices by issuing new shares means that each existing slice gets smaller.
So, dilutive transactions like this are quite costly for investors, and a reverse stock split may tell you that one such move is on the horizon.
The End of Forward Stock Splits?
While reverse stock splits are likely here to stay, forward stock splits may soon be a thing of the past. The goal of a company moving forward with a stock split is to reduce the price of shares in order to make them more accessible to the general investing public.
However, emerging financial technology is already starting to solve that problem. Seeing that high-cost stocks were inaccessible to smaller investors, many brokers — including big names like Robinhood and Schwab — offer investors the ability to purchase fractional shares. Instead of buying a single full share at whatever price may be required, investors can buy companies based on whatever dollar amount they have, and can be issued fractions of shares for the more expensive holdings in their portfolios.
This trend is relatively new but is already making high-priced stocks accessible to the average investor. Should more brokers follow along these lines, the forward stock split may become unnecessary, as investors will have access to purchase whatever stock they’d like in increments that cost as little as $1 or less.
Stock splits, both forward and reverse, are important tools that give companies the ability to adjust the price of their shares without any meaningful changes in the actual value of the company. Although these events are cosmetic at first glance, the long-term implications are important to consider.
Keep in mind, forward stock splits are just about always a good thing. They increase the demand for shares, and therefore the price. Conversely, reverse splits are often a sign that the company is struggling, and therefore could signal that further declines are ahead.