A GUIDE TO
STOCK SPLITS

A stock split is when a company increases the number of its outstanding shares by dividing its existing shares into multiple ones. Stock splits are often used to make shares more affordable and increase liquidity in the market.

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A stock split is quite a common phenomenon in markets and occurs on various exchanges around the world and at various times. This guide will help you understand what stock splits are, how they impact your stock positions, and how eToro handles them on the platform.

What is a Stock Split?

A stock split is a process where the management of a firm decides to increase the total number of shares of a company which are in circulation by issuing new shares. 

Each existing shareholder receives new stock at a specified ratio. If the stock split ratio is 2:1 then a shareholder owning 100 shares would see the number of shares they hold increase to 200.

As the underlying value of the company isn’t materially impacted during a stock split the price of each share on the exchange will halve. That means that the total value of the shareholders position will remain unchanged, they’ll just own more shares which each have a lower price.

Why do Stocks Split?

The main aim of a stock split is to reduce the price of the shares listed on an exchange. There are several benefits relating to this:

• Attracting retail investors: Some investors would rather not invest in certain stocks if the individual share price is too high. Carrying out a split would lower the price of circulating shares, thus, enabling more investors to buy stocks.
• Greater liquidity: The larger the number of shares that exist in the market, the greater the potential for liquidity. More shares can mean more transactions and more money changing hands.

• Psychological pricing: Analysts often say a certain stock is “overvalued,” meaning, its current price represents the sentiment in the market, rather than its actual worth. Splitting a stock reduces its price significantly, thereby providing the psychological effect that the share price is more inline with its peer-group.

A beginner investor looking to invest $1,000 into the stock markets should look to diversify their portfolio to reduce the chance that poor performance in one stock will impact the overall performance of their portfolio. If the price of Apple Inc stock is $250, then buying one share in the company would result in 25% of the portfolio being allocated to one position. 

Regardless of the potential for APPL stock, being “overweight” in one company poses a risk. If the Apple management team carries out a stock split, then that reduces the market price and lowers a barrier to entry faced by smaller investors.

When does a stock split?

The decision of whether or when a stock split occurs is made by the management team of a company. There is no fixed formula. Some companies split their stock price every few years, providing they show constant growth, while others refuse to split their shares, no matter how high the price of each individual stock climbs. When it comes to timing, companies will usually allow at least a few weeks between the announcement and the actual split.

How many Times can a Stock Split?

Theoretically, infinitely. Companies can split their stocks as many times as they wish. For example, between 1987–2003, tech giant Microsoft (MSFT) split its stock nine times. However, since there is paperwork and bureaucracy involved, companies will most likely only split stocks when they feel it is a good and timely decision for their business.

Legendary investor Warren Buffett took an alternative view regarding the ‘A’ class stock of his Berkshire Hathaway investment company. Deciding to not split the ‘A’ class shares, despite their soaring share price. Buffett’s view was that there were benefits associated with avoiding the administrative costs of processing a stock split and a higher share price would encourage long-term investors who intended to hold positions in his company for an extended period of time.

How do Stock Splits Affect Indices? 

Sometimes a stock split can influence an entire index. This is particularly likely if the value of the index is calculated using the price, rather than the market capitalisation of the stocks which make it up.

For example, the weighting within the Dow Jones Index (DJ30) is calculated based on share price. This means that if a stock splits, its proportional part of the index will diminish significantly. For example, Apple’s 2020 stock split changed it from being the top weighted stock within the DJ30 all the way down to number 16.

How does a Stock Split Impact Share Price?

The most immediate impact of a stock split is that the price of the stock in question will be reduced. The extent of the price fall will be determined by the ratio of the stock split.

Stock splits take place overnight whereas material changes to the fundamental prospects of a company generally take longer to process. That would suggest that the market capitalization of a company can be expected to remain the same regardless of a stock splitting, but throughout history, stock splits have usually been in favour of the splitting company, at least in the short term.

According to Bespoke Investment Group, between 2015–2020, the average price changes for stocks of companies that announced splits has been an additional 2.3% from the time the split was announced until the time it took place. Moreover, nearly 70% of these stocks outperformed the S&P 500 index during that time. While the average stock also fell 0.3% immediately after the split, over the following year, these companies gained an average of 9.8%.

Despite the above, it is important to note that there are numerous factors that can impact a stock’s price. The decision to split a stock may coincide with these other factors that can potentially drive a stock’s price higher. Past performance is not a guide to future returns, therefore, as positive as this analysis is, it may not be a reliable indicator.

What is a Reverse Stock Split?

A reverse stock split is the opposite of a stock split. In a reverse split, the company consolidates stocks, reducing the overall number of stocks in circulation. 

If a certain company announces a four-for-one reverse split, and each share is currently worth $50, the new share price would be $200 and a shareholder that has eight shares would now have two.

How does a Reverse Stock Split Affect Traders and Investors?

Unlike a normal stock split, in which the number of shares is simply multiplied by the split ratio, a reverse split could leave a shareholder with fractional shares. For example, if a certain shareholder has five shares, and the reverse stock split is four-for-one, they will end up with 1.25 shares. In this case, most companies would simply liquidate the fractional share and give the shareholders the difference in cash. However, on eToro, if such an event were to occur, positions would not be affected, since eToro enables fractional stock ownership.

How does a Reverse Stock Split Affect Traders and Investors?

Unlike a normal stock split, in which the number of shares is simply multiplied by the split ratio, a reverse split could leave a shareholder with fractional shares. 

For example, if a certain shareholder has five shares, and the reverse stock split is four-for-one, they will end up with 1.25 shares. In this case, most companies would simply liquidate the fractional share and give the shareholders the difference in cash. However, on eToro, if such an event were to occur, positions would not be affected, since eToro enables fractional stock ownership.

How do Stock Splits work on eToro?

eToro is home to numerous traders and investors who use the platform to invest in stocks with 0% commission. Since it has such a large stock offering, eToro is no stranger to stock splits, and has handled them in the past.

When such a market event occurs, eToro creates a seamless process of applying the split ratio to all related figures. The change will be applied to the total unit count and the average or current price. However, the value of each position will not change.

If a reverse stock split occurs, this means that a position that was previously composed entirely of whole shares could potentially now have fractional shares. However, the overall value of the position will not change due to the split.

eToro may communicate with its users ahead of time, letting them know of an impending split and if  any action is required on their part — although it is highly unlikely that there will be.

Final thoughts

Taken at face value, a stock split can be considered to be an administrative process which shouldn’t materially impact the value of your investments. But the situation can be more nuanced than that, as stock splits are typically a sign that a company’s share price has risen. 

Stock splits are seen as an indication of previous success and stories of a split occurring are shared by financial news sites which can increase the profile of a company and draw in new investors.

Learn more about managing your investment portfolio by joining the eToro Academy.

FAQ

Are taxes due after stock splits?

Stock splits are not a taxable event for investors. You are not buying or selling shares, and the transaction does not change your ownership interest. Income must be reported after the sale of shares, and that doesn’t happen with a stock split.

What is the adjustment to the futures and options contract due to a stock split?

If a stock split changes the price of a stock, the futures and options contracts relating to that stock are modified to ensure that their value is not affected by price changes resulting from the split.

For example, if a company’s shares are split 2-for-1, the number of shares underlying a futures or options contract doubles . The contract price is also adjusted, so the price per share is halved in the case of a 2-for-1 split.

Are stock splits good or bad?

Even if a stock split doesn’t affect the value of your investment, it’s usually a positive development for investors. It shows that the company is confident and intends to raise additional funds.