Stock splits have made a lot of headlines in the investment world lately. Amazon (NASDAQ: AMZN ), Google (NASDAQ: GOOG), Tesla, (NASDAQ:TSLA)and Shopify (NYSE: SHOP) these are just some of the major names that have announced them in 2022.
Studies from Art Journal of Banking and Finance shows that stock splits have historically had a positive impact on short-term returns. So, should companies that split their shares be admired? I believe there is one reason to be optimistic about these developments, but another strong reason to treat them with caution.
What is a stock split?
First, let’s define what a stock split it and why the company might want to implement it.
If a company’s stock price rises, it may eventually reach a level where average investors will struggle to afford even one share. Amazon, for example, recently traded above $2,000 before it underwent a 20-to-1 stock split, dropping its stock value to around $100. Shareholders received 19 additional shares for each they owned, and the value of those shares was reduced proportionately, leaving the company market capitalization without changes.
Lower stock prices make these stocks more affordable for retail investors. One of the main purposes of a stock split is to increase liquidityon the theory that a more reasonable price will attract more investors to buy the stock.
A stock split can indicate that a company is running on all cylinders
Let’s be 100% clear: A stock split should not be the reason you invest in any company. This financial maneuver does absolutely nothing to improve the long-term performance of the business.
However, I like to see a company go through a stock split, because most of the time it comes after a significant increase in share price, and thus usually indicates that the company is probably doing pretty well.
For example, after Amazon’s last split in 1999, its stock price increased by more than 3,000%. When a stock rises this much over 23 years, it’s usually because the underlying business is doing incredibly well.
Alphabet — the parent company of Google — split its stock in 2014 and has since risen nearly 300% to more than $2,000 per share. That made it a 20-to-1 split this month.
Look out for companies that are taking advantage of the stock split mania
Sometimes struggling companies try to use investor excitement caused by stock splits to boost their stock prices. For example, consider GameStop‘s (NYSE: GME) a recent 4-to-1 split.
The niche retailer’s share price volatility made headlines in 2020 when retail investors took a short dip in the stock, leading to a sharp increase in the stock price. Other attempts at a short squeeze followed, but since it peaked in January 2021, meme stock has fallen by more than 60%.
You can GameStop management’s motivation for the recent split was to bring in more retailers in hopes of triggering another squeeze. Or perhaps the low stock price of around $30 will make investors think they are undervalued. But it’s important to remember that absolutely nothing has changed in GameStop’s struggling business. His finances still a messand its valuation remains quite expensive price before booking the ratio is 7.5.
Investors should be wary when struggling businesses try to capitalize on stock split mania to boost their share prices. This is usually a trap.
Remember the analogy with pizza
The easiest way to think about a stock split is to imagine a pizza. No matter how many slices you cut the pie into, the total volume of the pizza remains the same.
It’s the same with companies. You can split the stock as much as you want, but the market capitalization will not change. Neither do the basics of the core business.
While it’s nice to see the big winners in your portfolio share, ultimately you’re better off focusing on the quality of the underlying business when making investment decisions.
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Suzanne Frey, CEO of Alphabet, is a member of The Motley Fool’s board of directors. John Mackey, CEO of Whole Foods Market, a subsidiary of Amazon, is a member of The Motley Fool’s board of directors. Mark Blank has positions in Shopify and Tesla. The Motley Fool has positions in and recommends Alphabet (A stock), Alphabet (C stock), Amazon, Shopify and Tesla. The Motley Fool recommends going long January 2023 $1,140 Shopify calls and short January 2023 $1,160 Shopify calls. The Spotted Fool has a disclosure policy.