Stock splits; no free lunch

Stock splits and reverse stock splits are common occurrences in the stock market. But realistically they don't mean anything. Here's why.

What is a stock split?

Let's look at what a stock split is using an example. In June 2014 Apple AAPL had a 7:1 stock split. If an investment account had 100 shares of AAPL prior to the split the value of the investment would have a market value of approximately $5,863.

From the table below you can see what the account would look like post split. With a a 7:1 split the account would now have 700 shares and the value of those shares would be adjusted accordingly. In this case they would be reduced by 1/7th bringing the share price to $83.76. Prior to the split the stock was trading around $586/share.

Note; the numbers are split adjusted and ignore changes in the share price which of course occurs all the time in the stock market. From the stock chart (below the table) you can see the stock price rose 1.6% on June 9th closing at a price of $85.10/share. The price change is irrelevant to the understanding of a stock split.

Apple's stock has split four times since the company went public. The stock split on a 7-for-1 basis on June 9, 2014, a 2-for-1 basis on February 28, 2005, June 21, 2000, and June 16, 1987. You can find the history of stock splits for all of your stocks of interest at Stock Split History.

What does it mean?

A stock split does not change the value of the underlying investment. All it does is change the share price and the number of shares, by the same ratio, as announced by the company for their split. Here's another way of looking at a stock split.

You go over to Granny's house and as always she has served a great dinner. Now out comes the desserts and this time she's gone all out. There are cakes and pies and you have to decide where to start. Usually you go for the cherry pie but this time there is a pecan pie which is a rare treat at the best of times. So you decide you're going to dig into the pecan pie this time. After asking around the table who wants some of that pecan pie an argument ensues as nobody can agree on what they're going to eventually eat. So instead of cutting the pie into two halves you compromise and suggest you'll cut the pie into quarters. You realize that if there is enough pie left over you can always have another piece. Here's what it would look like if you had just served yourself half the pie or if you wait it out like a good guest and eat two pieces of the pie after it was cut into quarters.

You may have ended up eating two pieces of pie instead of one but but the pieces were smaller (half the size). The total amount of the pie eaten was the same and the pie itself never changed its total size regardless of how many pieces it was carved up into. It's the same for the company who has undergone a stock split. Apple, in our example, did not undergo a change in its total market value. All that happened was the capital structure was sliced up into more shares.

Why do a stock split?

Companies will typically announce a stock split because retail investors have this thing where they think they can't buy higher priced stocks. By keeping their share price lower more retail investors may acquire the stock supporting the theory that more buyers will drive the stock price higher. After all the number one job for management of publicly traded companies is to make shareholders money.

The curse of reverse stock splits

A reverse stock split is when the number of shares is reduced for the purpose of raising the price of the stock (or any other type of security).

The reverse stock split is undertaken when the share price is so low (under $1) that any change in price becomes larger as a percentage change in value (securities trade in increments of one cent). It typically occurs in securities that have suffered a large decline and are effectively in danger of trading down to zero. So management declares a reverse stock split creating a higher share price. For any account that already holds the security the number of shares would go down by the corresponding increase in price. Let's use an example to illustrate.

Oil market security HOU is a two times performance E.T.F trading on the TSX (Toronto Stock Exchange). With a huge decline in the price of oil HOU went under a dollar in late April 2020. On April 28th a 1:20 reverse stock split or rollback went into effect. For every share previously owned an account would now have 1/20th the share quantity. See the table below and note the investment value or market value is the same (excluding normal price changes) on a split adjusted basis.

In the chart of HOU the date of the reverse stock split or rollback is where the red arrow is.

What stock splits teach investors

  1. A stock chart is a useful tool for understanding a security and what it means for your investment strategy. In both a stock split and a reverse stock split there is no free lunch. The trend pre-split typically continues after the split as seen in our two examples here. The trend is your primary indicator.

  2. Sell signals are your master: Stock market history has been a very valuable guide when it comes to security selection and stocks or E.T.F.s undergoing reverse stock splits are notorious examples. The lesson from HOU and other oil E.T.F.s isn't so much about understanding reverse stock splits it's to know what to keep your hard earned money out of.

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