It seems that stock splits have been all the rage lately, so it might be helpful for investors to better understand the process and avoid some common misconceptions associated with the maneuver. Here are the three most important misconceptions to avoid.
1. More stocks don’t mean more value
Take the example of Tesla’s recently announced 5-to-1 stock split. If the company goes ahead with its 5-for-1 stock split on August 28 and you previously owned 10 shares, your number of shares quintuple (increases 5 times) to 50 shares after the split. Does this mean that the value of your investment has also been multiplied by 5? No, the value has not changed.
The split has no impact on the value of the company’s assets or profits. Instead, it just affects the number of shares outstanding. The result is that your stake remains unchanged due to the dilution in the value of each share to perfectly offset the increase in outstanding shares. Regardless of that, stock bulletin boards and social media accounts are inexplicably loud (and wrong) about the promising impacts of a stock split. It would be wise to ignore this noise entirely, because stock splits have no impact on a company’s prospects.
2. Stocks haven’t gotten cheaper
Continuing our Tesla case study, the split will certainly have a direct effect on the price per share. If the stock was trading at $ 2,100 per share at the time of the split, that price per share would be divided by 5 to $ 420. Naturally, to some, it looks like the business instantly got 5 times cheaper, but it isn’t.
A post-split Tesla share controls only 20% of the earnings, assets and voting rights that a share controlled before the split. This means that you will need to buy 5 shares of the company for a total of $ 2,100 to achieve the exact same exposure as the $ 2,100 stock represented before the split.
Considering this, it becomes more and more clear just how little impact stock splitting actually has on a business. Why do companies do it then?
3. The potential reason for splits
Apple argued that the decision to divide its stock 4 to 1 was driven by a desire to make its stocks more affordable to retail investors. While this may have historically been true, with most brokerage firms now allowing users to purchase fractional stocks based on specific dollar amounts rather than whole stocks, this argument now has little merit.
I think it has a lot more to do with the desire of new investors to own 10 or 100 stocks rather than a share of a share. In reality, this does not affect the upside potential of an investment; it just feels better for a typical investor, and that makes sense. It seems that stock splits are more psychological than anything else.
Additionally, Apple’s announced equity division has run into incredibly bullish price action, regardless of whether that move is totally unrelated to the overall value of the company and future prospects. Maybe companies like Tesla have noticed the boost that this effortless move has given Apple and have decided to do the same.
The stock splits of Apple and Tesla have returned the subject to traditional discussions. From this perspective, it is important to understand the total lack of effect of these movements on the real value of a capital. Investors would do better to avoid basing their investment decisions on a stock split. Simply put: Divisions don’t matter.