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What are stock splits?

Quest: Stock splits

What describes stock splits best?

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Quest: Why would a company issue a stock split?

Why would a company issue a stock split and what might happen?

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You can’t always buy half shares. You have to buy one whole share (or more) or nothing. When a share is trading for $100, you can’t buy half a share for $50. For example, Apple was worth $500+ in 2020. Apple issued a stock split of 1:4. If you wanted to buy shares from Apple you Needed at least $500+ to buy one. After the split, shares cost $500 / 4 = $125. Now the people that don’t have $500 but do have $125 can buy shares from Apple. Basically meaning the stock becomes more attractive for investors with smaller pockets. Although, today (2022) many brokers offer the option to buy fractional shares. This allows the investor to buy a slice of a single share. 

Also, price has a very psychological impact on investors. Most people prefer having a higher amount of shares instead of a higher price per share. Because then you have more shares! But that does not make any sense because you still have the same amount of value. But thats how numbers work on a psychological level. For example, before the split you could only buy one Apple share for $500 now you can buy four. Four is more than one so it might seem you now have more.

8.1 Higher liquidity

A stock split might also result in higher liquidity. Liquidity means how fast a security can be bought or sold. A split causes a lower price per share which might attract more investors resulting in more availability of the shares in the market. Higher liquidity will also reduce the spread. Spread is the difference between the ask and sell price. The spread is lower because more people are trading the stock and are more likely to pay the price they want. More investors means more money for the company.

8.2 Reverse stock split

A reverse stock split can also take place. It acts the same as a forward stock split only reversed. For example, a company has 100.000 outstanding shares for $1 and issues a reverse stock split 2:1. The outstanding shares changed to 50.000 and price to $2 per share. Companies might issue a reverse stock split when the price of their shares are very low. Some exchanges require a minimum price per share or they get delisted. 

8.3 Stock splits can fundamentally change the market

Stock splits can fundamentally change the market. Stock splits tend to outperform the market for the next 12 months after the split. When a stock split takes place, the fundamentals of the company are exactly the same. The market capitalization did not change (outstanding shares * price per share). Although nothing changed, a stock split can fundamentally change how the stock is traded. 

And that makes sense because an optimal stock price can attract more investors. More investors means different behaviour in the market. This clearly shows that valuation of companies is based on psychological decisions and emotion and not based on true data. If the last was the case, the valuation of the company would stay exactly the same after a stock split because literally nothing about the company changed. They only changed the amount of stocks.

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