Why do big companies like Tesla, Apple, and Amazon like to split their shares

In 2022 alone, the world's three largest and richest tech companies — Alphabet Inc. (Google's parent company), Amazon, and Tesla — have all announced plans to split their stocks, and the announcement of the upcoming split itself has caused their stock prices to jump. For example, the day after Alphabet said it would split its shares on February 1, 2022, the company's stock price soared 7.5 percent.

So what is a stock split that excites investors? What kind of message is a company trying to convey by 2-for-1, 3-for-1, or even 20-for-1? We spoke with Derek Klock, a finance professor at Virginia Tech, about the psychology of stock splits.

What is stock split?

Unlike many financial terms, this term is fairly easy to grasp. A stock split is when a company decides to divide all of its outstanding shares by a certain number, whether that number is 2, 3, 5, or 20. The total value of the shares does not change, only the outstanding shares and their individual prices.

Think of it as change. If you have a $20 bill and exchange it for two $10 bills, the total value hasn't changed ($20), but now you're twice as numerous, and each note is worth half the value of the original bill. Now, let's say you swap a $20 bill for 20 singles, which is a 20-for-1 split. The total value is still $20, but the value of each banknote is one-twentieth of the original.

Stock splits work the same way. Suppose XYZ Company has 1,000 shares outstanding at a trading price of $1,000 per share. This means that XYZ Company has a market capitalization of $1,000,000. If XYZ Company had issued a 2-to-1 split, there are now 2,000 shares outstanding at a price of $500 each.

"A stock split doesn't change a company's market cap," Klock said. "It just changes the number of shares outstanding."

After the stock split, the total value of XYZ Company is still $1,000,000 (2,000 shares x $500), but the number of shares outstanding is twice the original. So, if you own 10 shares of XYZ Company worth $10,000, after a 2-1 split, you will have 20 shares that are still worth $10,000. That's because the stock price also "splits" from $1,000 to $500, so there is basically no change in economic value.

The decision to split the shares is made by the Company's Board of Directors and requires approval from the U.S. Securities and Exchange Commission (SEC).

Why should the company split its shares?

Historically, companies have split their stocks when their share prices are too high. But isn't a high stock price a good thing because it indicates a lot of demand for stocks? Yes and no. Rising stock prices are a sign of investor confidence in the company's future profitability, but if the stock price is too high, then ordinary investors may be overpriced.

Think like this. If this popular holiday toy costs $30 instead of $300, more people can afford it. If a company wants to attract more investors, especially new investors, then it wants to keep its stock price in a "favorable range," Klock said. For investors with limited funds, a $50 stock in a hot company is less risky than a $500 stock.

That's one of the reasons Amazon gave when it announced a 20-1 stock split on March 9 to "make it easier for people who want to invest in the company to get the stock price."

To be fair, it seems to work. When Apple made a 4-to-1 stock split in 2020, retail investors flocked to buy the stock. Retail investors are non-professional investors, i.e. people like you and me. When Apple lowered its price per share fourfold, retail investors went from buying $150 million a week in Apple stock to buying nearly $1 billion a week.

For Klock, however, the traditional rationale for a company to issue shares for a split is outdated. In the past, stocks were traded in groups of 100 shares by brokerage firms, and the high share prices did make the shares out of reach to everyone except wealthy and institutional investors.

But Klock said the investment landscape has changed completely with the advent of online trading — anyone can buy and sell stocks online for a low fee. Not only can retail investors buy individual stocks (instead of 100 shares), but online brokers like Schwab, Fidelity, and Robinhood also allow investors to buy stock "slices," which are a fraction of each share.

At Robinhood, for example, you can buy "bits and pieces" as small as one part per million, making any stock price affordable to invest.

So if lowering stock prices to a more "favorable" range is no longer a driver, why do companies like Alphabet, Amazon, and Tesla still split their shares? Crocker said announcing the stock split was primarily a way for the company to send "publicly positive signals" to the market that it expects its shares to continue to rise.

"It seems to me that [the decision to split the issue of shares] is almost entirely psychological and not any real financial reason behind it," Klock said.

What stock segmentation means for the average investor

So the question is, how should the average investor view this "signal"? If you own shares that are about to be split, should you hold them? If you're thinking about investing in a company, can a spin-off really tell you anything about its finances?

As Klock explains, the stock split doesn't tell investors anything specific about the company's earnings or profitability. This information is published in quarterly earnings reports. But a stock split is a reliable signal that people inside the company may know more about the company's future performance than anyone else, and they think things are only going to get better.

In terms of investment returns, the "positive signals" of a stock split seem to prove right. Nasdaq conducted a study in 2019 that looked at all major stock splits from 2012 to 2018. It found that simply announcing a stock split resulted in an average 2.5 percent increase in stocks, which outperformed other markets by almost 5 percent a year later.

So, if you already have a stock that is about to be split, the data indicates that the stock price may rise immediately. And, if you're thinking about investing in a stock that has just been spun off, there's strong evidence that the investment will pay off. Again, no investment is definitive, so consult a financial advisor before making any decisions.