Stock splits are a great way to increase investors' interest in a stock. A stock split does not change the value of the company, rather it spreads that value across more shares. But splits have a downside.
While the total market capitalization remains unchanged, stock splits result in a lower price point for each share. So, by splitting the share price companies may be able to get price-sensitive investors to buy the stock.
Stock splits increase the liquidity of the stock as well. This is because companies issue more shares when the split goes into effect. If we take a 2-for-1 split of XYZ stock, after the split 200 XYZ shares replace 100 XYZ shares at half the original share price.
Both due to the lower stock price that generates greater investor interest and the greater liquidity, a stock split can lead to strong price action in the near term, and even before the split.
For example, Amazon.com executed a 20-for-1 split on June 6, 2022. On March 10, immediately after the split was announced, shares jumped over 5% on strong volume. The rally took the stock up more than 25% to a top in August.
Excessive Stock Splits
But too many stock splits are not a good thing. IBD founder William O'Neil cautioned that a split can work both ways. It makes it more affordable for investors who want to buy the stock. But sellers may also use this as an opportunity to sell into the split-induced rally.
Also, stock splits are usually executed after a stock has had a strong run up. As a result, short sellers may see that as an opportunity to short the stock on the split. Greater short interest results in lower prices even for stocks that have been split. This is particularly true when a stock splits too many times, attracting sellers and pressuring the stock.
Nvidia's stock splits in 2006 and 2007 are a case in point.
The company made a 2-for-1 split on April 7, 2006. Shares fell after the split to a low in July before rallying again. The second split, which was 3-for-1, followed on Sept. 11, 2007, after a strong breakout from a cup-with-handle base.
Shares attempted to sustain the rally but failed and fell to a low in November 2008.
Market conditions also affect the outcome of a stock split. O'Neil noted that it "may be unwise for a company whose stock has gone up in price for a year or two to declare an extravagant split near the end of a bull market or in the early stage of a bear market."
This is because a strong short interest can quickly pull down a stock that has had a strong run-up, or that is already being pulled by a larger market downtrend.
Reverse Splits
A reverse stock split is when more shares are exchanged for fewer shares. Here too, the market capitalization and value of the company remain unchanged. However, by reducing the number of outstanding shares, companies make the stock more illiquid and pricier.
This strategy is common when companies hope to get their shares listed on an exchange or when they are trying to avoid getting delisted. While stock splits are frequently a sign of strength, reverse splits indicate possible underlying problems such as the risk of being delisted.
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