You walk into the bank with a crisp $100 dollar bill and ask the bank teller to give you five $20 dollar bills. You still have $100 Dollars, but are you any richer? The obvious answer is no. But the stock market tends to think otherwise.
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The Purpose of Stock Splits
The Summer of 2022 had a handful of notable stock splits – back-to-back-back – Amazon (AMZN), Google (GOOGL), and Tesla (TSLA). The average stock investor might have thought that something big was happening. Headlines reported the announcements of stock splits from some of the most well-known companies in the world. So, what was the purpose of all of this? Were the shareholders getting richer? There must have been a reason for it.
Let’s take a look at what a stock split and the purpose for doing so.
Amazon was the first to announces it will be doing a 20:1 stock split in June of 2022. That meant that for every one share owned, you would then have 20.
The thing is, only the number of shares increased, not the value of the shares.
Here’s an example of a stock split:
ABC Company, Inc.’s Portfolio:
- ABC Company, Inc. has 1,000 total shares for the company.
- Each share is worth $100 dollars.
- So, the entire company has a market capitalization (market value) of 1,000 shares* $100 = $100,000 Dollars.
ABC Company, Inc.’s Stock Split:
- ABC Company, Inc. decides to do a stock split of 25:1.
- Now the entire company has 25,000 total shares.
- Each share will be worth $4 dollars
- And the entire company market capitalization is still 25,000 shares* $4 = $100,000
- The company is still valued the same, but now the share price is much lower.
Key Lesson
The only difference is the change in the number of shares and the value of each stock – exactly proportional to the split ratio. If a stock split doesn’t provide a real benefit to the shareholders, what’s the point of it?
The answer is two-fold:
- Human psychology; and
- Getting included in the Dow Jones Industrial Average index (DJIA).
Using the methodology from above, we know that stock splits provide no added value to the company. But humans have several psychological biases, one of them being, sticker shock.
Prior to the 20:1 Google split, the price was approximately $2,200. Many unknowing stock buyers look at prices of stock, as if the price of it compared to another stock, has something to say about whether to buy it or not. They might have compared it to Microsoft being $250 dollars, seemingly more affordable, or being able to purchase nearly 10 shares of Microsoft for the same price. Surprisingly, many people think this way – even though it has no merit. After the stock split takes place, and people start seeing the price difference, it can entice them to finally make that purchase, even if it represents the same ownership as it once was. If a company can make its price attractive to more buyers, then eventually it could lead to a higher price via supply and demand.
Companies doing stock splits are now stating that they are doing so to help small investors. This might be so. Many small investors cannot afford to buy shares that are $1,000+, so they buy shares that are much cheaper. There are now companies that offer fraction shares, i.e., purchasing ½ share, ¼ share, and so on. These large companies are wise and make decisions that they believe will benefit the company and shareholders.
Exchange-Traded Funds (ETF). An ETF is a collection of hundreds or thousands of stocks or bonds, managed by financial experts, in a single fund that trades on major stock exchanges, like the New York Stock Exchange and Nasdaq.
Dow Jones Industrial Average Index
Getting included in the Dow Jones Industrial Average Index (DJIA) can offer benefits to shareholders by having more representation in ETFs and being known as 1 of the 30 companies that comprise the DJIA. Representation in ETFs means that when someone purchases an ETF, the ETF manager will need to acquire more shares of the company. The ETFs that hold the largest amounts of shareholder dollars are typically those that comprise of the S&P500 and the DJIA. The DJIA is comprised of 30 of the most prominent companies in each sector, and it’s based on an average price of those combined companies. So, if a company that has a high stock price could influence the DJIA price-weighting – it could affect the Dow Jones Industrial Average. For example, in 2014 Apple was around $700 per share, which was much higher than the DJIA average. Apple in turn, did a 7:1 split bringing the price down to around $100 per share. It was after the split in which they were included in the DJIA. (see below for the 30 companies in the DJIA)
“Since the indexes are price weighted, the Index Committee evaluates stock price when considering a company for inclusion. The Index Committee monitors whether the highest-priced stock in the index has a price more than 10 times that of the lowest.”
-Dow Jones Averages Methodology
This does not guarantee that Google will be included in the DJIA. The process is complex, the requirements are steep, and only 30 companies are part of it. It is interesting to note, that both Google and Amazon have taken this similar approach in the same year. They also took a 20:1 split in June 2022, bringing the share price from $2,500 to $125 – so they might have a similar agenda in this aspect. Both are very well-established companies and are leaders in their own sectors. Time will tell, but I would not be surprised to find one of these two companies, if not both in the DJIA in the next year.
Here’s a look at the 4 major stock splits that took place in 2022.
Conclusion
Stock splits usually won’t benefit shareholders in any immediate way. Wall Street media will talk the companies up and get investors thinking, but the truth is, it doesn’t provide direct value. The objective of the stock split is the appearance of a competitive price – even though the share price provides minuscule information about the company. This is the psychological sticker shock that was previously discussed. The other incentive that industry leading companies may be considering is being added to the Dow Jones Industrial Average. Being added to this would likely provide long-term value to shareholders simply for being perceived as a powerhouse in its industry. Thus, being added to the DJIA, it would likely create larger purchases of stock via ETFs, and other funds that are created to track the markets eventually leading to an increase in price.
I hope this provides some clarity for stock splits, and that there is no real reason to get excited about the current situation, and no true value is being created for shareholders. Some investors like Warren Buffett even believe that stock splits degrade a company’s shareholder quality – it’s one of the specific reasons he has never split Berkshire Hathaway’s Class A shares, which have reached $540,000 per share at one point.
Frequently Asked Questions – FAQ
What is a stock split?
A stock split is a corporate action in which a company increases the number of its outstanding shares by issuing more shares to current shareholders. This does not change the overall value of the company, but instead lowers the individual price per share.
Why do companies do stock splits?
Companies perform stock splits for a variety of reasons. One reason is to make the stock more accessible to smaller investors who may be deterred by a high share price. Additionally, getting included in a major index like the Dow Jones Industrial Average can also be a motivation for companies to split their stock.
How does a stock split work?
In a stock split, the company increases the number of its outstanding shares. For example, in a 2:1 stock split, each share that an investor owns is split into two. However, the total market value of the shares remains the same.
Do stock splits make shareholders richer?
No, stock splits do not change the total value of a shareholder’s investment in the company. If you owned a $100 share and the company performed a 2:1 split, you would now own two $50 shares. The total value is still $100.
What impact does a stock split have on the Dow Jones Industrial Average Index (DJIA)?
Being included in the DJIA could increase a stock’s visibility and demand, which may eventually lead to a price increase. However, since the DJIA is a price-weighted index, companies with a high share price can skew the average. Companies may execute a stock split to bring their share price more in line with other companies in the index, potentially increasing their chances of inclusion.
How does human psychology play a role in stock splits?
Many investors have a psychological bias known as “sticker shock,” which makes them less likely to purchase high-priced stocks, even if the valuation is reasonable. By lowering the price of individual shares through a stock split, companies can make their stocks more appealing to a broader range of investors.
How did the stock splits of Amazon, Google, and Tesla in 2022 affect their shareholders?
Although these stock splits increased the number of shares held by each shareholder, they did not increase the total value of each shareholder’s investment, as the price of individual shares decreased proportionately. The real effects of these splits may be seen over the long term if they result in greater demand for the shares and inclusion in major indices.
Do all investors view stock splits positively?
Not all investors view stock splits positively. Some, like Warren Buffett, believe that stock splits degrade a company’s shareholder quality and therefore, Berkshire Hathaway has never split its Class A shares. However, this view is not universal and some investors believe stock splits can provide long-term value by increasing liquidity and making shares more accessible to small investors.
