What Do Stock Splits Mean For The Investor?

“Cut my pie into four pieces. I don’t think I could eat eight.” – Yogi Berra

What does a stock split mean for investors? From a valuation standpoint, not a whole lot. All they’re doing is cutting the pie into more pieces, but the pie itself isn’t changing. Stock splits don’t affect the value of a company or its market capitalization (calculated by multiplying the number of outstanding shares by the current share price); they simply reduce the per-share price of the stock. If a company is trading around $500 before the split, the shares will be trading around $125 after the split (500/4 = 125).

Let’s look at an example to see how this affects a shareholder. Pre-split, someone who owns 100 shares of the company has an investment worth approximately $50,000 (100 x $500). Post-split, the shareholder will own 400 shares of the company, but their investment will still be worth $50,000 (400 x $125).

If it doesn’t materially affect the investment, then what’s the point of a stock split? It’s a bit of window dressing, really, to make the shares more accessible. Except in a few limited situations, stocks can only be purchased in whole shares. That could put the shares of companies with a high per-share price out of reach for many investors. In order to entice these investors, the company may split the shares and reduce the per-share price to a more affordable level.

Be careful not to confuse share price “affordability” with valuation, though. Valuation is the process of determining the worth of an investment by conducting various analyses.

Fundamental valuation, for example, considers metrics like cash flow, earnings, and profitability and evaluates an asset’s value based on these characteristics. The current price may be higher than its implied value (overvalued) or lower than its implied value (undervalued); however, price on its own tells you neither of these things.

A stock split is akin to the old dieter’s trick of cutting an apple into eight pieces instead of four; it’s the same amount, but it tricks the eye into seeing abundance and the belly into feeling full. Go ahead, enjoy your extra slices – you’ve earned it.

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