In this post we will talk about what a stock split is, why they happen and what it means to you as an investor.
Stocks
Before we dive into what a stock split is, we need to talk a bit about stocks and stock prices. As we know from the post on stocks here, a share of stock represents ownership in a publicly traded company. As an investor I am able to buy and sell shares of companies in capital markets.
Stock Price
The price of a stock is determined by supply and demand. Potential buyers place bids specifying the number of shares they’d like to buy and the price they are willing to pay. Potential sellers offer a specified number of shares to the buyers at a price at which they are willing to sell. Lots of bids and asks are made until the prices match, at which time a trade happens. Our brokers handle most of the heavy lifting to facilitate the transaction. Again, you can read more about this in stocks and capital markets.
Is it Really Cheap?
In my brief stint as a car salesman, there was a lot of down-time. The guys I worked with, a surprisingly nice and helpful group, would talk a lot about stocks. The general consensus was that low priced stocks were a bargain. I remember one of the stocks that got a lot of discussion amongst the car guys, and which was also a hot topic on wallstreetbets was Hertz (HTZ). Hertz was flirting with bankruptcy and was trading around $10 per share which the guys thought was a bargain. Especially compared to a ridiculously expensive stock like Alphabet (GOOG, GOOGL) which at that time was trading at a pre-split $2,000+ per share.
Were They Right?
While it is true that you could buy more shares of Hertz for your money, than you could buy of Alphabet, the number of shares you own is really only 1 piece of the puzzle. My response to the car guys was that if you wanted to buy a car, you could buy a used Yugo for about $500, or you could buy a used BMW 3 series for $25,000. Which is a better value for your money. At which point, they gave me the scrunched eyebrow look and went back to talking about how many shares of Hertz they were planning to buy.
How Do You Value a Stock?
This deserves a longer post (coming soon) but needs a little context before we can talk about stock splits.
The price of a stock represents the amount of money investors are willing to pay for a share of stock. It is published and is the price at which the most recent trade occurred. The value of a stock is different
There are lots of metrics used to value a company or a share of stock. One of the most common is Price to Earnings Ratio, or P/E for short. P/E represents what you as an investor will pay for the earnings of the company. It’s a simple ratio; price per share divided by earnings per share. P/E is a common measurement used in comparing the value of different companies, or stocks.
All things being equal, a stock with a lower P/E is often viewed as a better value than a higher P/E stock. Because the price you pay for the first company’s earnings is lower, it is more likely that the price will rise in the future. Again, this is just one of many metrics used in valuing stocks and there are lots of cases of higher P/E companies outperforming lower P/E companies. We’ll dig in deeper in an upcoming post.
Price and Value
We now understand what a stock price represents. Value is a bit elusive, but I think the car example is a good one. Low cost does not necessarily correlate to a good value. And, a good value for one person, may not be a good value for another. It also depends on what is important to you personally.
Stock Split
OK, after all that, we’re finally here. A stock split occurs when a company decides to reduce the price of its stock. A company does this by reducing the price, and at the same time, increasing the number of shares outstanding by a factor equal to that used in reducing the share price.
Amazon Stock Split
In June of 2022, Amazon implemented a 20 for 1 stock split. This was announced well in advance to allow shareholders and record-keepers to prepare. On the day of the split, Amazon’s stock price was adjusted down by a factor of 20, and the number of shares that each shareholder owned was adjusted up by a factor of 20. All of this occurs when the market is closed.
Amazon’s stock was trading at about $2,100 per share just before the split. On the day of the split, the share price was adjusted down to around $105 per share, and shareholders found their number of shares held increase by a factor of 20. So, if you had 2 shares of AMZN pre-split at a price of $2,100 per share, your AMZN holdings came to (2 x 2100) $4,200. After the split, you would have had 40 shares of AMZN (2 shares times the factor of 20), at a price of $105 per share (pre-split price of $2,100 divided by that same factor of 20), for an account balance of, you guessed it, $4,200.
Why?
There are a few reasons why a company would split its shares. Most importantly, in the past, splitting the shares improved liquidity. Today we are typically able to buy fractional shares through our brokerage, but in the recent past, this was not the case. We needed to buy full shares. Paying $2,100 for a share of AMZN was out of many potential shareholder’s reach. At $105, it is much more accessible.
There is also a psychological side to this. We like to see lower prices. We can envision a $7 stock going to $14 but it is hard to see a $2,100 stock going to $4,200.
Reverse Stock Split
While not as impressive as the Triple Lindy, some companies pull off the reverse stock split. In this move, they increase the price of the shares while decreasing the number of shares outstanding.
GE Reverse Stock Split
See the press release here. GE has been around since 1892 and is one of the pillars of American innovation and industrialization. My opinion, but it is a very important American company that has been involved in everything from finance to healthcare to jet engines to light bulbs.
GE has been a challenging investment throughout recent memory. It’s had a lot of ups and downs. In July of 2021, it implemented a 1 for 8 reverse stock split to increase its stock price from around $10 per share to $80 per share.
Why? Again…
In my opinion, the reverse stock split is a little more significant. As we saw with a traditional stock split, there is no real impact to the investor. The price changes, the number of shares changes, yawn, move on.
Here’s why the reverse split is more meaningful to me. Often times a company will execute a reverse split to prevent being tossed off an exchange like the NYSE or NASDAQ. The exchanges often have $ limits for stock prices and if the company’s price falls below, the company will be delisted. Delisting is bad.
Delisting
While the price decline into delisting territory could be the result of corporate actions, I start to pay attention when discussion of reverse splits starts to bubble up. In GE’s defense, in and around 2020, GE was divesting a number of its businesses. Selling off pieces of the company can cause the value of the stock to decline so the reverse split may be justified, but, like I said, I start to take notice and dig in a bit.
Investor Psychology
Similar to stock splits, there is psychology at play here as well. Many investors run for the doors when they hear the term penny-stock. As stock prices start to drop into the $10 range, they start to feel a little like penny-stocks. We may talk about penny-stocks in an upcoming post, but I’m not sure what more to say other than “stay away from penny-stocks.” If you want more, watch the wolf of wall street.
But Wait, One Reason They Do Matter
I will give you one reason why I may get excited about a stock split. In an earlier post, I talked about using covered call options to generate income. In this strategy, I buy shares in a company and then sell an option contract that gives another investor the right to buy those shares on or before a specified date in the future for a specified price. It’s a little complicated so read the post if you are at all interested.
Option contracts are written against round lots of 100 shares. That means if I sell a single call option, it gives the buyer the right to buy 100 shares at the specified price.
Option Example 1: Devon Energy
I only participate in covered call options which means I always buy the shares in advance of selling the option contract. This works great when I’m selling contracts on Devon Energy. Devon trades at $47.62 per share today. I can buy 100 shares for $4,762 and sell an option covering those shares. My risk is fairly low. I’m investing less than $5,000 on this idea.
Option Example 2: Amazon
Amazon is one of my favorite holdings, but prior to its 20 for 1 stock split in 2022, there was no way I was going to shell out $210,000 to buy 100 shares so that I could make some money on an option sale. Now the premium on the option would be huge, but the risk is way more than I am willing to take. Again, read the covered call option post for more on how these contracts work and the risks associated.
But, with Amazon post-split trading at $105, I can buy 100 shares for $10,500. It now becomes less risky for me. Sure Amazon’s stock price could dip, just as any company’s price could, but if it does, I have $10,000 at risk not $210,000.
Ouch
By the way, this is exactly what happened. Shortly after the split, I bought shares at $134 and wrote a call option against those shares. Not long after, the share price dropped to $84 per share. I am bullish on Amazon, so I held on, but I chewed a few nails down to the quick waiting for a recovery. Amazon trades at $174 per share today. Who knows tomorrow.
Wrap Up
We’ve talked a bit about stock prices, stock valuation, and traditional v. reverse stock splits.
The big take-away is that investors shouldn’t care. If you are a long term investor, this doesn’t matter. Just because a company splits, it doesn’t mean the stock is ready to go higher. Look at Amazon. Also look at Tesla and its recent split. Some go up, some go down.
Reverse splits could be a little more interesting so do some research and find out if the share price has been decreasing and what’s causing the decline.
And if you made it this far…why the picture of a pizza? It wasn’t just to make you hungry. It doesn’t matter if you cut the pizza into six slices or 8 slices. It’s the same pizza. Same thing with stock splits. It’s the same company regardless of how many pieces you carve it into. Stock splits have no effect on the value of your investment in the company.
Thanks for reading. Let me know what you think.