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Stock Splits: What All Investors Need to Know

Matthew Frankel, CFP, The Motley Fool

Companies split their stocks for a variety of reasons and in a variety of different ways. Here's what you need to know about the three main types of stock splits, how the process works, why it can be a positive or negative catalyst for a company's market value, and other important details.

What is a stock split?

A stock split occurs when a company either increases or decreases its share count without changing its overall value. For example, if a company doubles its share count by giving investors one additional share for every share they own, each shareholder will own twice as many shares of stock -- but the overall value of all outstanding shares won't change, as no additional capital will have been paid into the company.

Businessmen looking at financial charts on a screen.

Image source: Getty Images.

What is the most common type of stock split?

The most common type of stock split is a forward split, which is when a company increases its share count by issuing new shares to existing investors. For example, a 3-for-1 forward split would mean that if you owned 10 shares of company XYZ before it split, you'd own 30 shares after the split took effect. However, the overall value of your investment wouldn't change (at least in theory). So a forward split results in more outstanding shares but a lower per-share stock price, with no net gain or reduction in the company's overall market value.

Here's a quick illustration: Suppose you owned 20 shares of a $30 stock before a 3-for-1 split. Immediately after the split took effect, you would own 60 shares of a $10 stock. As you can see, the total value of your holding would be the same in either case.

The most common stock split ratio is 2-for-1 (doubling the number of shares and cutting the price in half), but 3-for-2 and 3-for-1 ratios are also common. Having said that, companies can generally use any split ratio that results in the desired price adjustment. For example, as Apple's (NASDAQ: AAPL) stock price ballooned a few years ago, the company decided to implement a 7-for-1 split.

What is a reverse stock split?

There's another type of stock split, known as a reverse split, that works in the opposite way. Shares owned by existing investors are replaced with a proportionally smaller number of shares. For example, a 1-for-3 reverse split would replace every three shares owned by a company's investors with a single share of stock. In other words, if you owned 30 shares of a company's stock before such a reverse split went into effect, you'd own 10 shares afterward.

Like a forward split, a reverse split doesn't change the company's market value, nor does it (theoretically) change the value of each investor's holdings. If a stock was trading for $10 per share prior to a 1-for-3 reverse split, it should be trading for $30 immediately afterward.

I say "theoretically" because a reverse stock split generally happens for a negative reason and can therefore worry investors, driving down the stock price. For example, major exchanges like the New York Stock Exchange generally require a share price above $1 as a condition of continued listing. So if a stock has performed terribly and has been trading for well under a dollar, a reverse split could bring the share price up to an acceptable level. In situations like these, a reverse split can be perceived as the company giving up on raising the share price naturally through its business.

How do stock splits create new share classes?

One special situation involving stock splits is when a company uses a split to create an entirely new class of shares.

A good example of this is Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG), which implemented a split of this nature in 2012. The company, which was still known as Google at the time, decided to create a nonvoting class of stock -- called Class C -- and issue one share of the new stock for every share of the existing Class A stock (the shares owned by the public) or Class B stock (the shares with more voting power owned by insiders). The idea behind the split was essentially to ensure that the company's top executives retained a majority of the voting power -- not to make the stock more affordable to everyday investors.

Real estate company Zillow (NASDAQ: Z) (NASDAQ: ZG) made a similar move in 2015, creating a nonvoting Class C alongside its existing Class A and B shares, which have a similar voting-power structure as Alphabet's stock. This was effectively a 3-for-1 split, as investors received two shares of the new stock for each existing Class A or B share they owned. Zillow said that the new stock was intended to be used to make acquisitions and to compensate its executives.

What should you expect when stocks split?

There are three key dates investors need to know when it comes to stock splits. They are (in chronological order):

  • Announcement date: First, the company will publicly announce the plans for the split, as well as pertinent details investors need to know. This information generally includes the split ratio and when it will happen, including the dates I describe in the next two bullet points. In addition, companies will often discuss their motivation for the split, especially if it has to do with the health or structure of the business, which is typically the case in a reverse split or creation of a new share class.

  • Record date: This is an important date when it comes to accounting, but it isn't terribly important for investors to know. The record date is when existing shareholders need to own the stock in order to be eligible to receive new shares created by a stock split. Simply put, if you buy after the record date but before the split is effective, you'll be entitled to receive new shares when the split takes effect (I'll explain this shortly).

  • Effective date: The date when the new shares show up in investors' brokerage accounts and the stock begins trading on a split-adjusted basis.

Here's what to expect in real-world situations. Between the date of the announcement and the close of trading on the day before the effective date, it's business as usual. The stock will continue to trade just as it had before the announcement. At some point between the close of trading on the day before the effective date and the market's open on the effective date, the effects of the split will appear in your brokerage account.

On the morning of the effective date of a forward stock split, the increased number of shares will appear in your account, and the share price should be adjusted accordingly. In the event of a reverse split, this is when you can expect to see the number of shares in your account reduced and the share price increased. In the event of the creation of a new class of stock, this is the date when you'll notice two stock positions listed in your brokerage account instead of just one.

Why do companies split their stock?

The most common reason a company would split its stock is to make its shares cheaper for investors to buy. Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) is a textbook example of an affordability-driven stock split. By 1996, the company's original shares (now referred to as class A shares) had become too expensive for the average investor to own, so to prevent predatory investment vehicles from being created so the public could invest in Berkshire, CEO Warren Buffett decided to create another class of shares by splitting the originals 30-for-1. Since then, Berkshire's B-class stock has split again at a 50-for-1 rate, so these shares now have 1/1,500th of the equity of each Class A share.

Again, the primary motivation was to keep the stock affordable. Most retail investors can't afford the roughly $300,000 price tag of a Class A share of Berkshire Hathaway. However, the $200 Class B shares are easily accessible.

Some companies have split their stock periodically throughout their history in order to maintain a desirable share price. Starbucks (NASDAQ: SBUX) is a good example. From 1993 through 2015, the company has split its stock six different times, at a 2-for-1 ratio every time. This means that if you owned Starbucks shares prior to Sept. 30, 1993 (the first split), and had never sold, you'd now own 64 shares of Starbucks for every share you originally owned.

Do stock splits create value?

I've touched on this a few times, but it's worth mentioning one final time in order to be perfectly clear. A stock split doesn't have any effect on the overall value of your investment.

For example, in a 5-for-1 split of a $200 stock, you should end up with five $40 shares to replace each of your $200 shares. With a 1-for-100 reverse split, you should end up with one $100 share to replace 100 $1 shares. The stock split itself has absolutely no effect on the total value of the company.

That said, the circumstances surrounding the split can certainly move a stock higher or lower.

For example, when a company decides to implement a forward stock split in order to make shares more affordable, it can be a positive catalyst. This opens the stock to an entirely new subset of the investing public who previously may not have been able to afford even a single share, which can cause a spike in demand that pushes the stock higher.

Alternatively, a reverse split is almost always seen as a negative by investors, as it's generally a signal that there's trouble in a company's business. For example, MoviePass majority owner Helios and Matheson Analytics (NASDAQ: HMNY) executed a 1-for-250 reverse split in 2018 that was intended to prop the stock up to an exchange-acceptable level. It did -- for a little while. Shares promptly fell back into penny-stock territory as investors realized just how much their shares could be diluted as the company issued new stock to raise capital.

When a stock splits to create a new share class, it can go either way. Alphabet's move was largely seen as a selfish and unfair way for executives to maintain absolute power and was viewed negatively by investors. Here's a look at the stock's price in the days following the announcement on April 12, 2012.

GOOGL Chart

GOOGL data by YCharts.

Forward split case study: Apple's 2014 stock split

When Apple announced its stock split on April 23, 2014, here's what the company's press release said: "Each Apple shareholder of record at the close of business on June 2, 2014 will receive six additional shares for every share held on the record date, and trading will begin on a split-adjusted basis on June 9, 2014."

Here's what this meant to investors. For simplicity, I'll use round numbers instead of Apple's actual stock prices at the time.

Let's say that Apple had traded for $700 per share at the market's close on June 8, the day before the split went into effect. For investors who already owned Apple stock and who held through at least June 9, the process was pretty straightforward. For every share of Apple they had in their brokerage account on June 8, which was worth $700, six more shares of Apple appeared in their brokerage account before trading began on June 9. Each of the seven shares was worth $100 immediately after the split went into effect.

Here's where the corporate accounting concept of a record date comes in. Let's say that someone bought a share of Apple on June 4, 2014 -- after the record date but prior to the effective date. In this case, the new shares would technically be given to that share's prior owner. However, because they sold their share prior to the split's effective date, those new shares would be transferred (by the brokerage) to the investor who bought the shares.

In a nutshell, anyone who purchased Apple stock prior to the June 9, 2014, effective date of the 7-for-1 split would have received six new shares.

Reverse split case study: Helios and Matheson Analytics

I briefly mentioned Helios and Matheson Analytics, but here's a closer look at how the infamous MoviePass owner's reverse split worked.

Unlike most forward stock splits, which are thoroughly planned, Helios and Matheson moved quickly to prevent a crisis. The company held a special meeting of stockholders on July 23, 2018, at which shareholders approved a one-time reverse stock split.

The very next day, on July 24, 2018, the company announced a reverse split in a 1-to-250 ratio that was to go into effect that same day at 4:01 p.m. EDT. On Wednesday July 25, the stock began trading on a split-adjusted basis.

Why such a hurry? The dramatic reduction in the number of outstanding shares allowed the company to issue new shares at a higher price in order to raise capital.

To say that investors were not thrilled with the plan would be a major understatement. The split initially had the desired effect, with shares spiking to a non-penny-stock level on July 25. However, sellers rushed in, and the stock quickly plummeted to a level even lower than before the split became effective. As of March 25, 2019, the stock trades for just over a penny per share.

HMNY Chart

HMNY data by YCharts.

New share class case study: Zillow

Real estate company Zillow announced a 3-for-1 stock split on July 21, 2015. However, this was not a standard forward split -- the company was creating a new class of stock.

For every existing Class A or Class B share investors owned, they were to be issued two shares of the newly created Class C stock. The new Class C shares represented the same amount of equity as the other classes but had no voting power.

The company's reasoning for issuing a nonvoting class was to give it flexibility in future decisions, such as issuing stock awards to employees and making acquisitions. And the new stock could be used to issue new common equity without diluting the voting power of existing shareholders. It's fair to say that shareholders weren't sold on the plan, as the general direction of the stock was downward in the weeks following the announcement.

ZG Chart

ZG data by YCharts.

The bottom line on stock splits

To sum it up, a stock split doesn't affect the overall market value of a company all by itself. Rather, it is simply a change in the share count or structure of a company's stock. However, while a split itself doesn't affect the value of a stock, the circumstances surrounding the stock split, as well as the split-adjusted stock price, can certainly be a positive or negative catalyst.

More From The Motley Fool

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Matthew Frankel, CFP owns shares of Apple and Berkshire Hathaway (B shares). The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Apple, Berkshire Hathaway (B shares), Starbucks, Zillow Group (A shares), and Zillow Group (C shares). The Motley Fool has the following options: short January 2020 $155 calls on Apple and long January 2020 $150 calls on Apple. The Motley Fool has a disclosure policy.