What is a Stock Split?
WHAT IS A STOCK SPLIT? REGULAR AND REVERSE
Let’s have a quick conversation about stock splits, both regular and reverse. You may have never heard the term reverse stock splits and be wondering if this is a real thing. Yes, they do exist even though they are rare.
Even though stock splits are a relatively straightforward issue, I wanted to cover it a bit for a couple of reasons.
First, I don’t want to assume everyone understands what a stock split is. That happens too often in my world, even though the financial industry likes to make things more complicated than they often need to be. The second is because it is front of mind as Sherwin-Williams, which is in my neck of the woods of Northeast Ohio, recently announced a 3 for 1 stock split.
The simplest definition of a stock split is it is a corporate action approved by the board that increases the number of outstanding shares. That’s it. It is then achieved by dividing the number of shares into more shares. The creation of more shares then reduces the stock price for each individual share. Here’s a critically important point I cannot stress enough. Even though there are more shares the company’s total market cap stays the same. Additionally, your overall value for the shares you own does not change either. Another super important point here!
How about we cover a simple analogy of what a stock split is. In this case a 2 for 1 split. Imagine you have a $100 bill and someone offers you two $50 bills for it. Nothing changes for you when you look at the total as you still have $100. You now simply have two bills adding up to that previous total dollar value as opposed to one. Now, no one would get excited about this, but if it happens in the world of stock splits people get interested. I wonder if this has anything to do with the financial services industry making things more complex than they need to be (please note sarcasm font).
Stock splits are so common there is a sub-industry within my world where people have created newsletters dedicated to reporting on companies who have splits in the pipeline. I have never seen any documentation that companies which do stock splits have better overall performance though. This certainly doesn’t slow people from selling newsletters in case anyone wants to try and make money off the splits. In this case, maybe only the newsletter salespeople make the money, but I digress.
Back on topic here. When it comes specifically to company stock splits, let’s say AAA Industries has 1 million shares with a total market cap of $100 million. Each share is worth $100. If they decide to do a 2 for 1 stock split there will now be 2 million shares at a price of $50 a share. The market cap remains at $100 million. Nothing has changed except the number of shares out there and the individual share price.
COMMON TYPES OF STOCK SPLITS
I’ve mentioned 2 for 1 stock splits a couple of times. It’s because this is a common form of stock splits. Other common forms are 3 for 1 or 3 for 2. 3 for 1 is easy to follow. Say your share is worth $750 and through a 3 for 1 split you will have 3 shares now each worth $250. This is exactly what is happening with Sherwin Williams at the end of March and first day of April. Although their stock price is $680 as I write this.
A 3 for 2 takes a bit more math. At least I need to break out the calculator as I’m not so good with numbers (please note that is a bad joke in my world as a CFP®). Actually, all you do for a 3 for 2 split is divide your original number of shares by 1.5.
A reverse stock split is exactly what it sounds like. Instead of a company taking a stock worth $1,000 and splitting it into 2, they may instead do something like take a stock worth $20 and do a 1 to 5 reverse stock split to combine five shares into one. The new share is worth $100.
WHY DO COMPANIES SPLIT THEIR STOCK?
So why do companies do stock splits? Good question. There are a couple of main reasons. First, as a stock price rises it may become harder for people to buy. Imagine trying to buy a share of a company with a stock price of $1,000 vs one with a price of $100. Takes a lot longer to save up for the former stock price. Another reason, which is probably more important to the company, is stock splits increase liquidity.
In the cases of reverse stock splits, companies usually go this route if their stock price has dropped. There are more complex reasons why reverse stock splits happen, but I’m not going to touch on them as this type of split is less common.
Again, no matter whether it is a regular old stock split or a reverse one, the total market capitalization does not change. Nor does your overall value change immediately either. The only things that change are how many shares you own and also the individual share price.
IMPORTANT DATES WITH STOCK SPLITS
One last point with splits. There are a few key dates to know. The first is anyone who is a shareholder of a certain date will be part of the split. The next is the close of business of a specific date, usually a few days after the shareholder of record date, where the split will happen after the close of business. This is simply the last day when the stock will trade at the higher price because the next day is the first day the stock will trade under its new split setup.
Once again, I’ll refer to the situation coming up with Sherwin Williams. The shareholder date is March 23rd. If you own a share at the close of the 23rd then after the close of business on March 31st you will then have 3 shares on April 1st. Yes, April Fool’s Day. Not the best timing, but it is the start of the second quarter of the calendar year so maybe that’s their reason as to the dates. Regardless, if one share of SHW is worth $750 at the close of the market on March 31st, one share will now be worth $250 on April 1st, although there will be two more shares each worth $250 for a total of 3 shares worth a combined $750.
EQUITY COMPENSATION AND STOCK OPTIONS
As a Certified Financial Planner™ who caters to clients retiring with large equity compensation positions, the topic of stock splits does come up. One reason is because of companies like Sherwin-Williams announcing their upcoming split. Honestly, it doesn’t really change the financial and retirement planning we are doing. However, if anything it is a positive thing.
Why? Well, because it causes people to spend a bit more time on their transition to retirement. I wrote recently about transitioning to retirement with equity compensation, but here’s a direct link if you need one. In the perfect world, the transition to retirement takes a year or so and is more involved than just giving your notice one day, followed with a party for your retirement and then a gold watch. Well, at least that is what the commercials on TV make it look like😉
That’s it with the basics of stock splits. I know I could have gone much deeper, but I have a funny feeling only finance nerds such as myself would be interested. Hopefully you are a bit more knowledgeable than before.
FLASHBACK – ARCADES!!!
In this week’s flashback I am heading to one of the coolest hangout places when I was a kid. And I’m highly confident if you are a fellow GenXer you had a similar place. I’m talking about an arcade.
For me, it was called Funsville. Initially, it was located within walking distance from my house as a kid. Or at least a similar arcade was. After arcades became more popular the new location went about a mile up State Road from my house. This was then Funsville.
Funsville was probably like arcades across the country. It was an arcade full of video games, music, awful pizza, other teenagers including girls I had never seen before, entertainment was 25 cents a turn, and all within a short 10-speed bike ride from my house.
My friends and I had paper routes, so we were rolling in the dough. At least enough dough to spend a few bucks a week on video games. Honestly, we didn’t play many video games as most of our time was spent walking around with a pop in our hands and meeting new people. Most of us had all gone to the same Catholic grade school since 1st grade and this was our first taste of freedom and meeting new people. We suddenly met all kinds of kids our age from our hometown and other schools, which was amazing.
Pretty much every weekend if the weather was decent, and we didn’t have sports messing up our plans, we met up at Funsville. It was a great year plus when we visited there on a regular basis. I don’t recall ever going there once I hit high school. At that point we were too busy going to sporting events, freshman dances at the school, or to a new friend’s house. However, riding your bike to play video games, get hopped up on sugar and caffeine, and meet new people, especially girls, was an awesome experience.
Oh, and you may be wondering if I had a favorite game. I did. I dominated Galaga. If I put a quarter on that game I was there for what seemed like forever. In reality it was probably no more than 10 minutes, but that was an eternity when your purpose of visiting Funsville was to socialize.
As always, thanks for taking the time to read this. Please do not hesitate to reach out if I can be of help with your equity compensation-related questions. The easiest thing to do is to click the little green box that reads “Schedule a Meeting” that can be found at the bottom of every page on my website. Or, just click my Calendly link right here.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.