Slicing the market pie: How stock splits work and why they matter

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Why would a company divide its shares?

© Dmitry Tsvetkov/stock.adobe.com

If you’re just learning about stock splits, you may have heard some variation of the pizza analogy. It goes like this: A stock split is like cutting a pizza. Whether you cut it into four or eight slices (or you square-cut it into 24 slices), it’s still the same pizza.

That’s a stock split. A company may split its shares by a factor of 2:1, 4:1, or even 10:1. The number of shares increases, but the price per share goes down in proportion, so in the end, the company’s total value is the same before and after a split.

A stock split is a company-driven decision to create more shares by dividing existing shares into multiple new shares. The value of the total shares—the company’s market capitalization—remains the same; there are just more of them.

Here’s an uber-simple example:

That’s pretty straightforward. But when you look at the motivations behind a stock split, you’ll find it can get complicated. Stocks are essentially valued based on today’s fundamentals plus expectations of tomorrow’s fundamentals. It’s that second part that can affect a company’s value in and around a split.

Some companies see a stock split as something of a win/win proposition:

For example, take the Amazon (AMZN) 20-for-1 stock split in 2022. Before the split, a single share would have cost an investor around $2,785. After the split, the price of each share was around $139. That’s pretty affordable. And consequently, the stock popped more than 4% on the day of the split.

Not all companies believe stock splitting is a good idea. Take Berkshire Hathaway (BRK-A)—technically an insurance underwriter but actually a holding company for legendary investor Warren Buffett and his management team. As of May 2023, a single share was trading for about $500,000. That’s well above the cost of an average American house.

Why doesn’t Buffett and team split Berkshire’s shares? He believes the stock should “parallel” the value the company has accumulated over time. That being said, Berkshire does list a separate (“B”) class of shares (BRK-B) that as of May 2023 trades at about $325 per share. The B-shares are splittable (and in fact, did a 50:1 split back in 2010), and they hold much less voting power than A-shares, but they are much more accessible.

Stock splits tend to generate “abnormal returns,” according to a Columbia University study. And because the company’s fundamentals don’t change per se, perhaps there’s something to the “signaling effect.”

According to the Columbia paper’s findings, analysts tend to bump up their earnings forecasts after a stock split. As a consequence, these companies tend to see better future earnings growth for up to two years after the split, as compared to their peers.

In other words, historical consistency does speak in favor of splitting companies, but remember that ultimately, the long-term fundamentals of a company are what eventually validate or invalidate its stock’s price, regardless of whether it chooses to split its stock.

Historically, bullish outcomes tend to follow stock split events, often in the form of higher earnings expectations and sometimes earnings growth. But you shouldn’t take it for granted—nothing is certain in the world of stock picking.

Some active traders used to buy a stock a few weeks before the split and sell it just a few days before the actual split. This worked at one time, but these days, enough traders seem to have figured out the play, making it less reliable (and lucrative). What was once a self-fulfilling prophecy is now just an outdated tactic that may not be worth your time, effort, and risk.

That being said, if a split might affect a company’s inclusion (or exclusion) from an index, there may be opportunities. At minimum, it’s something to pay attention to.

Stock split ratios are often 2:1, 3:2, and 3:1, according to FINRA. But as mentioned, Amazon split 20-for-1 in 2022, as did Google parent Alphabet (GOOGL). Apple (AAPL) split 4:1 in 2020 and 7:1 back in 2014.

A reverse stock split combines two or more shares into one share. The general perception is that they’re bearish.

Why are reverse splits bearish? For one thing, a company whose shares are dismally underperforming may choose to do a reverse split to (artificially) drive up the price of the stock. It might look like a bait and switch, but in some cases, it’s necessary.

For example, companies whose stock prices fall below a certain price risk getting booted from the New York Stock Exchange (NYSE) or Nasdaq. Raising their stock prices via reverse split may be the only way to stay listed.

During its golden years, shares of General Electric (GE) split several times. But when the company fell on hard times during the 2010s, shares sank so low that “The General” slashed its quarterly dividend. In 2021, GE did a 1:8 reverse stock split, which reduced the share count from about eight billion shares down to about one billion and, in turn, bumped up the share price eightfold, from about $5 to $40 per share.

Just as a pizza is still a pizza no matter how you slice it, a stock split doesn’t change the fundamentals of a company.

But that’s where the analogy ends. Stock splits can often stoke demand, whether through increased accessibility, demand from fund managers, and/or the “signaling effect.”

Although stock splits are generally bullish—at least in the short term—the company’s fundamental performance over time is what will determine the future value of each share. So if you’re looking to invest in a stock that’s about to split, remember to base your decision on the company’s overall health and growth prospects and whether it fits with your investing objectives.