Why Do Companies Engage in Stock Splits?

When a company’s share price increases to levels that are too high, or are beyond the price levels of similar companies in their sector, they may decide to do a stock split. The reason for this is that a stock split can make shares seem more affordable to small investors (even though the underlying value of the company has not changed). This has the practical effect of increasing liquidity in the stock.

When a stock splits, it can also result in a share price increase—even though there may be a decrease immediately after the stock split. This is because small investors may perceive the stock as being more affordable and buy the stock. This effectively boosts demand for the stock and drives up prices. Another possible reason for the price increase is that a stock split provides a signal to the market that the company’s share price has been increasing; people may assume this growth will continue in the future. This further lifts demand and prices.

In June 2014, Apple Inc. split its shares 7-for-1 in order to make their shares more accessible to a larger number of investors.1 Right before the split, each share’s opening price was approximately $649.88. After the split, the price per share at market open was $92.70 (648.90 ÷ 7).2

Existing shareholders were also given six additional shares for each share they owned prior to the stock split. So, an investor who owned 1,000 shares of AAPL before the stock split had 7,000 shares after the stock split. Apple’s outstanding shares increased from 861 million to 6 billion shares. However, the market capitalization of the company remained largely unchanged: $556 billion. The day after the stock split, the price had increased to a high of $95.05 to reflect the increased demand from the lower stock price.2

What Is a Reverse Stock Split?

Stock Exchange Images, Stock Photos & Vectors | ShutterstockAnother version of a stock split is called a reverse split. This procedure is typically used by companies with low share prices that would like to increase their prices. A company may do this if they are afraid their shares are going to be delisted or as a way of gaining more respectability in the market. Many stock exchanges will delist stocks if they fall below a certain price per share.

For example, in a reverse 1-for-5 split, 10 million outstanding shares at $0.50 cents each would now become 2 million shares outstanding at $2.50 per share. In both cases, the company is still worth $5 million.

In May 2011, Citigroup reverse split its shares 1-for-10 in an effort to reduce its share volatility and discourage speculator trading. The reverse split increased its share price from $4.52 to $45.12 post-split. Every 10 shares held by an investor were replaced with one share. While the split reduced the number of its shares outstanding from 29 billion to 2.9 billion shares, the market capitalization of the company stayed the same (at approximately $131 billion).3

How Do Stock Splits Affect Short Sellers?

Stock splits do not affect short sellers in a material way. There are some changes that occur as a result of a split that impact the short position. However, they don’t affect the value of the short position. The biggest change that happens to the portfolio is the number of shares being shorted and the price per share.

When an investor shorts a stock, they are borrowing the shares with an agreement that they will return them at some point in the future.4 For example, if an investor shorts 100 shares of XYZ Corp. at $25, they will be required to return 100 shares of XYZ to the lender at some point in the future. If the stock undergoes a 2-for-1 split before the shares are returned, it simply means that the number of shares in the market will double along with the number of shares that need to be returned.

When a company splits its shares, the value of the shares also splits. For example, suppose the shares of XYZ Corp. were trading at $20 at the time of the 2-for-1 split; after the split, the number of shares doubles and the shares trade at $10 instead of $20. If an investor has 100 shares at $20 for a total of $2,000, after the split, they will have 200 shares at $10 for a total of $2,000.

In the case of a short investor, prior to the split, they owe 100 shares to the lender. After the split, they will owe 200 shares (that are valued at a reduced price). If the short investor closes the position right after the split, they will buy 200 shares in the market for $10 and return them to the lender.

The short investor will have made a profit of $500 (money received at short sale ($25 x 100) less cost of closing out short position ($10 x 200). That is, $2,500 – $2,000 = $500). The entry price for the short was 100 shares at $25, which is equivalent to 200 shares at $12.50. So the short made $2.50 per share on the 200 shares borrowed, or $5 per share on 100 shares if they had sold before the split.

The Bottom Line

A stock split is used primarily by companies that have seen their share prices increase substantially. Although the number of outstanding shares increases and the price per share decreases, the market capitalization (and the value of the company) does not change. As a result, stock splits help make shares more affordable to smaller investors and provides greater marketability and liquidity in the market.

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