Of all subjects people ask me about, stock splits are probably the most prevalent. People get very excited about it, because they have the sense that a stock split is like getting something for free. But stock splits actually don’t happen for the reasons that most people think.
First, what is a stock split? Let’s take as our example a 2 for 1 split (there are many other types, 3 for 2, 3 for 1, even 5 for 4). It’s very much like going into a grocery store and getting two $5 bills for one $10. Not really very exciting. With stocks, it works like this. You have 100 shares of a $120 stock. After a 2 for 1 split you have 200 shares of a $60 stock. Before and after you $12,000 worth of stock. And it doesn’t matter if you buy before the split, after the split, or between the time the split is announced and happens, or if you buy stock options or anything else related to it. There is no advantage, just like there is no advantage having one $10 or two $5s.
Many people would say “Ah, but now I have twice as many shares and they will rise at the same rate, so I’m making twice as much money now”. But the truth is that they will rise (relatively) at 1/2 the rate as before, if all things are equal. But since you have twice the number of shares, net you’re in the same position.
Some people believe it’s to make their stock more accessible. Buying 100 shares at $60 is a lot easier than buying 100 shares at $120 for the average person on the street. This used to be a valid argument. But that was back in the 1960’s and before, when individuals bought stock on their own. Now 90% of all stock is controlled by institutions, including mutual fund companies. If you are buying $1 million worth of stock at a time, what do you care if the stock is $60 a share or $120 a share?
So why do companies do stock splits? Have you ever seen a nature show where you watched gazelles run from a cheetah or a lion? They have this really strange way of running. Instead of running flat out, they spring high in the air as they run. This behavior is called ‘stotting’. What the gazelle is doing by springing high in the air while it runs is to say to the cat “I’m young, I’m strong, I can leap high in the air, I can keep this up all day, so don’t bother to chase me”. Stock splits are a form of stotting. Companies cannot advertise their stock in the newspaper. But they can send a signal to the market in the form of a stock split. Saying in essence “Our company is strong and will grow, so buy our stock”. Stotting.
The only problem is, you can’t tell if management is just doing wishful thinking, or if they really are that strong. Many companies that split don’t perform well afterward. But take a company like Berkshire-Hathaway which has never split. It was $40 a share in 1972. Now it’s around $55,000 a share. Not splitting hasn’t effected their growing stock price.
One more thing. There is something called a reverse split. That is when a company might do a 1 for 10 split, so someone who has 1,000 shares at $2, will end up with 100 shares at $20. Oddly enough this is done for the same reason, to tell the market it’s a good company and worthy of investment.
A stock split isn’t really a reason to get too excited about a stock, much as Wall Street wishes it was.