Why do companies do stock splits?

Nvidia’s stock is up 10.7% on the day, now sitting at $1,051 per share, after the company reported excellent quarterly earnings. However, if current prices hold, it will only be worth $105 per share next month thanks to a 10:1 forward stock split. Shareholders don’t need to worry though, as they’ll receive 9 additional shares for each one they own.

A brief primer on stock splits:

A stock split doesn’t change the total value of the company, it simply adjusts the numbers of shares that value is divided between. For a real-world example, the amount of pizza in the below clip never changes, but the number of slices does.

Technically, stock splits shouldn’t change anything. However, announcing a stock split is often seen as a bullish signal, and companies that announce stock splits actually outperform the S&P 500 overall in the 12 months following their announcements.

Companies only announce stock splits after the stock price has increased significantly which, typically, is a sign that the company is doing well, and companies that have been doing well tend to continue to do well. AQR Capital Management noted that 200 years of evidence shows that momentum is a real phenomenon in investing, and strong performers continue to outperform.

It’s not necessarily that stock splits cause the price to increase further, but they signal that the company is doing well, which, in turn, means that it will likely continue to do well.

That being said, companies tend to do stock splits to make the stock more accessible. High prices can price out retail investors, employees, and other potential shareholders. Chipotle, for example, is trading above $3,000 per share now, and two months ago, the Tex-Mex chain announced that it was would have a 50:1 forward stock split, the first in company history, to “make our stock more accessible to employees as well as a broader range of investors,” according to CFO Jack Hartung. Nvidia echoed this message in yesterday’s earnings call as well. Since many brokerages, including Fidelity, Schwab, Interactive Brokers, and Robinhood offer the ability to buy fractional shares of a company, this argument in favor of share splits rings a little more hollow than it used to. (Sherwood News is an editorially independent, fully owned subsidiary of Robinhood Markets).

Stock splits can have a material impact on one market segment: indexes. Many stock indexes, such as the S&P 500, are market capitalization-weighted, meaning that the most valuable stocks get the heaviest weighting. However, the Dow Jones Industrial Average is price-weighted. So when a company in the DJIA announces a stock split, its weighting in the index drops. That’s why UnitedHealth Group, which is worth $475B, is weighted more than twice as heavily as Apple, which is worth $2.9T. United’s stock price is $516, while Apple’s is $188.

While some companies split their stock to make it more accessible, Warren Buffett’s Berkshire Hathaway famously refuses to split its Class A stock for the opposite reason. When asked about a stock split in Berkshire’s 1995 shareholder meeting, Warren said the following:

“We want to attract shareholders who are as investment-oriented as we can possibly obtain, with as long-term horizons.

And to some extent, the publicity about me is negative, in that respect. Because I know that if we had something that it was a lot easier for anybody with $500 to buy, that we would get an awful lot of people buying it who didn’t have the faintest idea what they were doing, but heard the name bandied around in some way…

So we are almost certain that we would get — we don’t know the degree to which it would happen — we are almost certain we would get a shareholder base that would not have the level of sophistication and the synchronization of objectives with us that we have now. That is almost a cinch.”

Accessibility was a con, not a pro, for Buffett. (Though one year, later, Berkshire did introduce Class B shares, which are currently worth 1/1500 of a Class A share, which much lower voting rights).

While companies that are doing well do forward stock splits, companies that are performing poorly sometimes have “reverse stock splits.”

Take Canoo, for example. Canoo is an electric vehicle startup that went public in December 2020, but it hasn’t done so well since. If you look at the stock chart below, you would think, “Wow, Canoo fell from $300 per share to $2 per share. I wonder if it can recover?”

But Canoo was never $300 per share. It announced a deal to go public at $10 per share, and the stock price briefly jumped in December 2020, as investors were excited about electric vehicle growth. But the startup failed to deliver (literally), and, as its stock price fell below $1, it received a delisting notice from the Nasdaq.

In order to get its stock price back above $1 per share, Canoo did a 1:23 reverse split, which is the opposite of a forward split. This time, your 23 shares would be replaced by 1 share, at a higher price. While forward splits are typically bullish, reverse splits, which are really a Hail Mary to avoid getting delisted, rarely bode well for companies.

So, while stock splits and reverse splits don’t mathematically change the value of a company, they do provide hints at how well a company is doing.