Stock splits are an interesting topic. There appears to be a widespread belief that a stock is somehow worth more after it splits and a somewhat related myth that lower-priced stocks have less risk and more return.
The best way for an individual to think about stock ownership is as if they were buying the entire company. If you were going to buy the entire thing what would it be worth?
Suppose ACME is worth $1,000 and there are 100 shares outstanding. Each share is obviously worth $10. If the stock is split 2/1 there are now 200 shares each worth $5 because the company is still worth $1,000. The investor’s position is unchanged. If the stock split 10/1 instead of 2/1 there would be 1,000 shares each worth $1 and many investors might have the mistaken idea that it is a great investment now because it appears so cheap (“It used to be $10!”), but the company has exactly the same value, in total, as it did before.
Another (frequently used) analogy would be cutting a cake. Cutting a cake into more slices does not mean you have more cake.
Now, there are three things about splits that are positive though:
- If the stock has a very high price per share, then splitting it will increase demand because more people have the wherewithal to buy it. This is rarely true (even Berkshire Hathaway has “B” shares that are affordable).
- Management doesn’t split the stock if they think it might go down. They will be pretty certain that the business is going to do well (this applies to dividend increases also) before they make that announcement. Thus the market, appropriately, takes the announcement as a very good sign for the company’s future.
- There may be people who mistakenly (as explained above) believe it is a better deal post-split because the price is lower and they may purchase the stock driving up the price slightly. To the extent they do this, the more knowledgeable market participants will be selling at the “too high” price (or possibly even shorting the stock). In an illiquid stock though, the ignorant masses (so to speak) could move the price.
Now despite those reasons that a split is positive, there still isn’t an investment opportunity because the price will move on the announcement not on the split (actually it will begin moving on the anticipation of an announcement). Stock prices (actually all securities prices) incorporate known information which certainly includes things that have been announced. So the announcement from management is a good signal, but it is the announcement, not the actual split that moves the price (to the extent it wasn’t already anticipated).
Let me explain that anticipated part as well. Using our earlier example ACME is “worth” $1,000 with no split announcement. If there is a split announcement, analysts, investors, etc. will raise their expectations for the future of the company and value it say at $1,100 (essentially non-public information – management’s strong belief in the future – has become public). Suppose there is a 90% chance that an announcement will be made. (Obviously opinions will vary as to probability, current value, value after the announcement, etc., but assume these are the consensus estimates.) In that case the stock will already be trading at $1,090 ahead of the announcement reflecting the 90% chance that it is worth $1,100 and the 10% chance it is worth $1,000. (Obviously in real life there are more than two possible futures and each one of those futures has an attached probability, but the concept is identical.) You can only profit as an investor by having a better estimate than the average of all market participants. This is extraordinarily hard to do.