With the recent stock split announcements from Tesla and Apple, it got me thinking as to whether the average investor truly understands how stocks work.
Although stock splits are common, my guess is stock splits are not completely understood by the average investor and even some advisors.
A stock split is thought to be a good thing. It is however one of life’s better examples as to the difference between perception and reality.
There are two types of stock splits: A common “split” and a “reverse” split. Due to the complexity of the two events I will cover the reverse split in next week’s article.
A common “split” is the type more investors are familiar with. It entails a company giving current shareholders more shares.
For example, if you own 100 shares of ABC company and they undertake a 2 for 1 split, you are given one extra share for every share you own which is why it is called two for one. You end up with two shares instead of one.
So in a 2 for 1 split, instead of having 100 shares you would end up with 200 shares.
A 3 for 1 split would mean you would end up with 3 times as many shares (300). A 4 for 1 split would mean your 100 shares would become 400 shares.
Sounds great right?
Not so fast.
What many investors don’t realize is whatever the ratio is for the split, the stock price is reduced by the same (negative) multiple.
So if the share price is $10 and you originally have 100 shares, you have $1,000 worth of stock ($10 x 100 share = $1,000).
If the company announces a 2 for 1 stock split, you end up with 200 shares, but the stock price drops to $5 the day of the split. Your new amount of shares is 200, each worth $5. Net worth of stock? The same $1,000.
Simply put, if they double the amount of stock, the price is cut in half.
Do a 3 for 1 split and the share price is cut in thirds while you end up with 300 shares, and so on.
Think of it like taking a pencil and breaking it in two. You now have two pencils but no more actual pencil than you started with.
The question then becomes, if an investor ends up with more shares after a split but each share is worth that much less, how does he benefit?
It’s all perception.
In a stock split, there is no monetary gain to the shareholder.
There is a reason however a stock split is thought to be a positive thing for existing shareholders.
After a split the stock price is lower. In the basic presumption of the theory of economic demand, a lower price means more demand.
Indeed, if a stock price is lowered through a split, that can mean more people may buy the stock, and the more buyers there are for a stock, the higher the price may go.
For a real world example, the share prices of both Tesla and Apple when split, will come down dramatically.
Tesla did a 5 for 1 stock split with a share price in the area of 1400 when announced. That means for every share of Tesla you own, you will get four more. The price of Tesla will be cut by that same percentage, meaning Tesla shares will be in the $300 range instead of in the thousands.
Apple did a 4 for 1 split, so its price will drop to 25% of what it is the day of the split.
Although the actual split garners the shareholder no real advantage in the math of the split, the reality of the lower stock price means more people may buy the stock.
Indeed, as a generally accepted belief, investors like lower priced stocks. If a stock price is too high, fewer investors will buy it and if a stock price is lower, more people may buy it.
Stock splits look to take advantage of this investor propensity.
This article expresses the opinions of Marc Cuniberti and should not be construed as individual investment advice. No one can predict market movements. Investing involves risk. You can lose money. Mr. Cuniberti is an investment advisor representative through Cambridge Investor Research Advisors Inc. a registered investment advisor. California insurance license 0L34249