Stock Splits & Reverse Stock Splits: Why companies do them & What they mean for you

With some notable companies like Apple and Tesla announcing stock splits and more people speculating that another FAANG company (Amazon) might be on the way to announcing a stock split of their own, it is essential to understand what stock splits and reverse stock splits are, why companies do them and what they mean for you.

When corporations decide to list their stocks on a stock exchange (sell their stocks to the public), they also determine the number of shares they want to list. The number of shares that are released to the public are called outstanding shares. They rise and fall in value based on the demand for them. Sometimes, the price for one unit of a company's outstanding shares grows so much that it can become too expensive for average investors. A high price may also make the stock harder to sell because the more expensive the stock gets, the fewer the number of people that can afford to buy 1 unit of it.

When this happens, a company might decide to take action to reduce the price of one unit of its stock. To do this, they have 2 options, release more shares to the public or do a stock split. If the company decides to release more shares to the public, this can increase the number of outstanding shares available to the public and in turn reduce the price, BUT this would dilute the ownership of the company because as more people buy the shares, there would be more shareholders who would be involved in decision making. Also, if more shares are available, the people who previously had shares would have a lower amount of ownership if they do not buy more shares.

Think of it like this, If a library had 10 books and you donated 6 of those books, this means you donated 60% of the books in the library, and you are the largest donor. If someone donates 10 more books to the library tomorrow, this means the library now has 20 books, and the 6 books you previously donated would now be 30% of the total books available, and you would no longer be the largest donor.

With companies, diluting ownership can be problematic for some reasons: for example, before a company takes certain decisions, it needs to be voted on by the shareholders. If the majority of shareholders vote on something that may not be good for the company in the long run, the company has to make those decisions. Also, having more shareholders means its more difficult to get all shareholders to vote. So to avoid diluting ownership, they have to consider the other option.

Stock Split

This is simply dividing the existing outstanding shares into smaller units. Like in the case of Apple, the price of one share before their 2020 stock split was around $420. They did a 4-for-1 split this means that for every 1 Apple stock you had, you would have 4 Apple shares after the stock split. So a shareholder that previously had 1 Apple share at $420 would now have 4 shares at $105 ($420/4). This also means that the existing shareholders' ownership remains the same. Back to the book example, if the library decided to divide all the 10 books they had into 2 books instead of receiving the extra 10 books, this would mean that they would have 20 books in total. The 6 books you donated would be 12 books, and 12/20 is still 60% of the holdings and you're still the majority donor. So, a stock split allows companies to kill 2 birds with one stone, reduce their share price while keeping their existing ownership stake the same.

In the case of Apple, 1*420 is 420 and 4*105 is also 420, so the total value of the company and each investor's holdings would remain the same after the split.

Stock split and reverse stock split can better be explained if you think of a stock like a box of pizza or a full cake before it is sliced.

If you slice a 10 inches pizza/cake into 10 slices, would the full cake/pizza (total value of the cake/pizza) still be a 10-inches cake/pizza? Yes. What about 100 slices? Yes, it's still a 10-inches cake/pizza. What about 1,000 slices? Still the same cake/pizza. The only difference would be the number of slices. Assuming the cake/pizza was for a party, every person at that party gets only 1 slice of cake/pizza, and the number of slices determines the number of people that can be invited to the party, it would mean that the more slices you make, the more people can join the party.

That's sort of how stock splits work. If 1 share is divided into 4, the total value of the share will remain the same, and more people can buy the cheaper stocks. But unlike a party, stock prices are affected by demand and supply. When Apple stock was $400, only people that could afford to spare $400 to invest in Apple could buy 1 stock of Apple share. But if Apple decides to divide 1 share into 4 (a 4-for-1 stock split), then this means that the people that could afford to buy 1 share of Apple stock before can now buy 4 and their share would appear cheaper to those who could not buy it before. As more people buy more Apple shares (higher demand), the stock price increases.

Another reason why companies might have stock splits could be to make it cheaper for them to buy back their outstanding shares. As explained earlier, the more outstanding shares are available to the public, the more diluted the ownership of the company is. If a company wants to reduce the number of owners of their company shares, they can either announce a reverse stock split or buy back some of their shares. Announcing a reverse stock split might not give a good signal to the public (more on this later), so the better option would be to buy back their shares.

You might be thinking, but wait, if the stock split makes the price of the share cheaper, it also means more shares are outstanding so even if its cheaper to buy the shares, there are still more shares available to buy. So, why didn't the company buy the share before the stock split instead of doing the stock split, and buying the shares after? Since there would still be more shares after the split.

• There's this thing called "change in unrealized gains/losses on marketable securities" that can be found in the "statement of comprehensive income" (the income statement) of companies. If you buy 1 share of a company at $100 and the share increases to $110 immediately, you have made $10, BUT that gain you have made is "unrealized gain" because until you sell that share, that $10 profit is not yours. On the other hand, if the share price falls to $90, you have lost $10, but until you sell that share, that loss is unrealized. Companies can hold investment in shares for years before they sell their shares.
• If a company bought 1 share for $10 in January 2018 and that share rises to $12 in December, the company has made an unrealized gain of $2 in 2018 if they don't sell their shares. In 2019, if that share rises from $12 to $15, should they put the gain as $5 in their 2019 financial statement since the initial cost of the shares were $10, and the shares are now worth $15 or should they put the change in unrealized gain which is $3 (total gain of $5 minus the gain of the previous year, $2)? The accounting standard states that they should put the change in unrealized gain to avoid double counting the gain. Remember, the financial statement for each year tells you the gain made in that specific year, so the gain that should be recorded is the gain for that year and not the gain for that investment over the years.

If the price of their share remains high, the demand for their share will not change so much even if they buy back their shares, but if they do the stock split and buyback more shares, their share price would increase by a higher degree as more average investors are also buying more shares. The profit they would get in the form of their "change in unrealized gains/losses on marketable securities" would be higher which would, in turn, increase their net profit and the Earnings Per Share (EPS). One of the formulae of EPS is net income/total shares outstanding. If the net income can increase due to their profit from the changes in share prices and the total outstanding shares can reduce due to their share buybacks, EPS would increase.

Example: If a company's net income was 100 and total shares outstanding was 500 in 2019, then EPS would be 100/500, which is 0.2. If they choose to do a 2-for-1 stock split in 2020, their total shares outstanding would now be 1,000 shares (2*500). If their net income increases to 200, their EPS would be 200/1000, which is still 0.2. BUT if the company decided to buy back 300 of their total outstanding shares in 2020, their net income would now be 250 because of the additional gain they could get from "changes in unrealized gains/losses on marketable securities" and their total shares outstanding would be 700. The EPS would be 250/700, which is 0.357, which is higher than them not doing the buyback. If the EPS of a company is higher than market expectations, it will signal that the company is doing better than the market expected and further increase the share price of that company.

In summary, companies do stock splits to make their shares cheaper which could increase demand and their share price and also make it cheaper for them to buy and eventually increase EPS and share price.

Reverse Stock Splits

Back to our cake and pizza: If you have too many small-sized pizza/cakes, it might seem like a good thing at first, but as the party starts getting together, you might find that 1 tiny piece of cake would not be enough for most guests so some people would take more than 1 and others wouldn't get any. After a while, you might find that your parties might be a turn off to guests who have larger appetites who might find the size a bit insulting and not want to come to your parties anymore. The same could be said for stocks.

To be listed on any stock exchange, there are requirements a company has to meet. One of the criteria to be listed on the New York Stock Exchange is the stock price of the company should be $1 or above at listing, and the share price should not fall below $1 for a period of 6 months, and if this happens, the company could be delisted from the exchange. Another reason companies do this is to appeal to institutional investors. While cheap shares are good for retail investors; mutual funds, pension funds, and some other institutional investors cannot invest in them because it goes against their set company/investment policy or by law they are prevented from investing their funds there. So when the share price of a company falls below a certain amount, it could make institutional investors sell off the millions of dollars worth of shares they own which could cause the company's share price to fall.

In summary, companies undergo reverse stock splits to prop up their share prices, avoid being delisted from the stock exchange and appeal to institutional investors.

Why do announcements of stock splits and stock splits cause the price of a company to go up?

As seen in Tesla and Apple shares, it's a bit more psychological. Making something appear cheaper generally makes it easier for people to convince themselves to buy it. It's also easier for a $10 share to go to $11 than it is for a $1000 share to go to $1100 (both 10% gain). If you think of it, there'll be no addition to the intrinsic value of the company, the company would still be worth the same thing, 400 * 1 = 100 * 4 but which one appears cheaper to the psyche? Which one appears like it has more room to grow and a higher likelihood of filling that room? The cheaper option.

Also, when companies do stock splits, it gives a good signal to markets that the shares of that company are doing so well and going so high that they had to split it. It shows that the demand for that company share is high and might continue to grow because of the stock split. This further increases demand and prices.

The opposite seems to happen after a reverse stock split occurs.

As it is with a stock split, when a reverse stock split happens, nothing new has happened to the company or the shares of the company. For a company to be trading at a price below $1 for months, it could mean that investors do not feel confident in that company, and there is not enough demand for that company's shares. If the company chooses to do a reverse stock split, they have not changed anything in their business that could inspire investor confidence. This would not increase demand immediately as such; the stock prices could continue to fall.

I would also guess that when a few investors that might not be aware of the stock split decision see a sudden rise in the share price of a company they are investing in, they might think that the stock price has risen by several folds and sell their shares only to discover that nothing happened to the total value of their shareholdings cos remember 10 x 10 is 100 and 50 x 2 is also 100. While this might not be a significant factor, I imagine that there might be a few investors that could act in this manner.

Also, when companies do reverse stock splits, it is not a good sign. It shows that the demand for that company share is not high enough to keep their share price high, so this bad signal could also inspire people to cut their losses and sell the company's shares. This, coupled with the performance of the company from the past, may cause the shares to decline.

What should you do when you hear a company announce a stock split or reverse stock split?

Nothing if you were not previously looking to buy their shares. While a stock split might mean that the shares are going to rise in the future, this might not always be the case. Sometimes, the price might fall before it rises. While a reverse stock split might mean that the shares are going to continue falling, this might also not always be the case. There are other things to consider before you buy a company's shares. You can check out this article for some tips on how to make stock market investment decisions.