We do know that stock splits do not affect the valuation of the business and that it exists in order to boost the liquidity of the share and make share affordable to wider base of investors. Also, historical data clearly shows that there is more volatile price movement and heavier trading volume around the announcement and execution day of a stock split. So – what’s the deal with stock splits?
Firstly, what is a stock split exactly?
First of all, we should clarify and very clearly determine what a stock split actually is. It’s the decision made by the company board to increase (could potentially decrease too!) the shares outstanding of the company. But effectively, nothing else changes – the underlying business does not change in any way. On the announcement day, investors get to know that a stock split is going to happen, just the same as the announcement of a dividend, approximately. This is the day when the market gets new material information and has an opportunity to price it in (price what in exactly if nothing changes?). The actual stock split happens on ex-date, which is again, the same as with dividend ex-date – you have to be the owner of a share on ex-date to experience said change. After the ex-date, a stock starts trading at a new price. If a 2-for-1 stock split happened, a new price would be halved, for example. In fact, this new price is the most important (and only) thing that changed.
To simplify, if the company announces a 2-for-1 stock split and a shareholder that holds 1 stock with a market price of EUR 100, after stock split execution he would own 2 stocks of EUR 50, experiencing no impact on his portfolio – ceteris paribus. So we should clarify what happens in between as the term „ceteris paribus“ is not representative in this case.
Let’s get back to our shareholders. They now own 2 shares with a price of EUR 50. Still, the total value of shares did not change. Each of their dividend payments now pays out half of what it used to – but they own two of them – so again, nothing changed. To emphasize, even dividend yield did not change as both share price and EPS were halved. But the aftermath is clear – higher volatility and heavier trading volume are reported around the announcement and execution day of a stock split. So, the conclusion is very clear: it’s all about the lower share price – in nominal terms. A lower share price makes a company’s share more accessible which has a positive impact on its demand. Simply put, more people can buy the stock of a company they believe in, if the share’s price is, for example, halved in the nominal terms. The higher accessibility reflects in a greater demand resulting in heavier volume and higher volatility, at least short-term speaking. This potential growth in demand due to higher accessibility is the only thing changed.
Stock splits in vogue on US equity market
Stock splits are very common on American equity market. On 28 March 2022 Tesla Inc. unveiled plans that it would seek to do another stock split for the second time in two years. In this year, already Amazon and Google ‘s parent Alphabet have announced they both plan to do 20-for-1 stock splits. Since these companies are in strong demand of investors, by reducing their share price their attractiveness grows further. Further to that, investors usually interpret these announcements as signals of confidence by management, and after announcement share prices have increased significantly. Tesla shares have risen 8% on the day of the announcement, while Alphabet and Amazon rose 7.4% and 5.4%, respectively, in the trading sessions after the companies’ said splits were planned. In US where a fractional trade of stocks on different platforms is possible is not so relevant but we can see that it boosts liquidity. So, in Europe where this practice is not so common, it is expected that it would serve the liquidity of the respective stock even more.