Stock splits may seem like a gift to some investors, but there is little evidence that you benefit in any meaningful way when a company splits its stock. This article will focus on the benefits and drawbacks of splitting stocks.
Benefits of Stock Splits
Some investors are scared of high-priced stocks, especially those priced over $100 per share. These investors would rather buy 100 shares at $50 each than 50 shares each priced at $100, even though there is no economic difference between the two.
Companies are well aware of this preference for lower prices and offer stock splits to make their stock prices “friendlier” to the small investor. Split stocks supposedly benefit from increased “liquidity,” the ability to sell stock without affecting its price.
See Also: Effects of Inflation in Stock Prices
While economists may see stock splits as a neutral occurrence, some advisers tout them as a bullish signal and encourage investors to buy stocks that are about to split. Apparently, stock prices temporarily increase right after a split, but the effect disappears quickly.
Nonetheless, corporations may use stock splits to signal that their businesses are doing well. Once again, this benefit is more psychological than financial.
It’s Not a Reverse Split
While stock splits are probably neutral, reverse splits, where many old shares turn into fewer new shares, is certainly negative. It signals that a stock price has fallen to an “unrespectable” level. A reverse split calls attention to a stock price decline and raises a lot of questions as to why the price is so low.
Below $5 per share, a stock is at risk of being delisted from the stock exchange, which would severely handicap the company’s ability to raise new equity funding.
The Long Run
One of the most rewarding investments a person can make is to own shares that have a repeated pattern of growing and splitting.
Take, for example, a stock with a history of climbing — following a split — to around $64 from $32 roughly every 24 months. A person who starts with 1,000 shares at $32 and who rides out the two-year cycle ends up with 2,000 shares representing the same total value as before the split.
Drawbacks of Stock Splits
Lower price stocks are psychologically easier for shareholders to sell. As share prices rise, investors perceive the value of each share as being great. They also tend to associate a high price with successful company management and growth. Once share prices drop after a split, more impulsive selling commonly occurs.
Over time, stock splits create record-keeping challenges for company accountants, analysts, and shareholders. A typical historical chart shows how a share price rises and falls over time. When you split a stock, the chart would obviously reflect the quick drop in share price.
Normally, companies split stocks when things are going well and the share price is on the rise. However, an excessively aggressive split may lead to risks if the share price falls too much going forward.
For the company, splitting stock is not free. Stock splits result from either a board of directors meeting and decision or a vote of shareholders. Either approach has costs. Also, the company must meet listing exchange and legal requirements by letting shareholders know the date and effects of the stock split.
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