The market loves a stock split, but should you?
Red-hot artificial intelligence (AI) chipmaker Nvidia (NVDA) made headlines recently by announcing its high-profile stock split. It's common for high-growth companies to split their shares to make them easier for smaller investors to trade and to add liquidity. But what does that really mean? And how does it affect you as an investor?
Let's start with the basics.
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A stock split is when a company issues more shares of stock to its existing shareholders without diluting the value of their holdings. For example, let's say you start with 100 shares worth $100 a piece. After a 2-for-1 split, you'd have 200 shares each worth $50. Assuming no other movement in the stock price, you have $10,000 in stock both before and after the split.
Why do companies do stock splits?
Stock splits at their most basic level come down to making the shares easier to buy and sell, which increases liquidity. This is best explained by example.
Prior to its split in 2022, Amazon.com (AMZN) shares traded hands at $2,447. After its 20-for-1 stock split, shares traded for $122 ($2,447/20). Now, if you are a small investor interested in buying the stock, it's a lot easier to come up with $122 than it is to come up with $2,477.
It's also easier to properly balance a portfolio. Let's imagine you want to make Amazon a 3% piece of your $100,000 portfolio. Well, with AMZN trading closer to $122, you'd be able to buy to about 25 shares to make that possible. But with Amazon trading at $2,447, you'd only be able to buy one share.
Of course, Amazon's pre-split pricing looks extremely affordable compared to Warren Buffett's Berkshire Hathaway (BRK.A) Class A shares, which trade for $630,000 a piece. But then, Buffett is eccentric and specifically wanted to reduce day-to-day trading in his company's stock, preferring to have loyal, long-term investors. He certainly got his way. On a typical trading day, only about 13,000 Berkshire Hathaway shares change hands.
What do stock splits mean for you as an investor?
If you are an existing shareholder, it's debatable what the immediate impact for you will be. Often, the buzz surrounding a stock split causes the price to rise leading up to the split and then in the trading days immediately following. But the data here is mixed and certainly not conclusive enough to suggest buying a stock simply because it’s planning a split or has recently done a stock split.
There can also be administrative issues to deal with. If you have any outstanding orders with your broker, such as stop loss orders, they are not always automatically adjusted. You might need to make adjustments manually. You'll also want to keep good records, because you can’t always depend on your broker to correctly adjust your cost basis for tax purposes. Mistakes like these are less common today with modern record keeping, but they can happen.
As a practical matter, stock splits really don't matter all that much. Sure, they make it easier for prospective investors to start a new position, and they make it easier for existing investors to rebalance or sell part of their holdings. But nothing fundamentally changes.
That said, a stock split is often a sign that a company is healthy and growing. After all, if the stock price has gotten high enough that a company feels the need to split the shares, then they’re clearly doing something that is getting the attention of investors.
