A stock split is when a publicly owned company divides its shares of stock, creating more shares. A 2-for-1 stock split, for instance, means for every share of stock you owned before the split, you have two afterward. While you now own two shares of stock instead of one, the value of each share gets halved. If, for example, you owned one share of $20 stock before the split, you own two shares valued at $10 each after.
This decrease in value makes share prices more affordable for investors, which is often the goal of the split. Despite their good intent, stock splits do have some disadvantages for both companies and shareholders.
Downsides of stock splits include increased volatility, record-keeping challenges, low price risks and increased costs.
Change in Volatility
Splitting a stock reduces the value of a single share, making it easier for smaller investors to purchase the stock. Some companies, however, don't want to make their shares easier to trade.
This is because of volatility. Volatility refers to the price change of a stock. When a stock's price changes frequently, investors refer to the price as volatile. Generally, the more volatile a stock, the riskier an investment it is.
Like all goods and services, stock prices fluctuate with supply and demand. The more affordable a stock, the more likely day traders and other short-term investors are to purchase it. Once share prices drop after a split, more impulsive selling is common. As these frequent traders buy and sell the shares, they impact the stock's price and may increase its overall volatility. To combat this, some companies prefer to keep high stock prices where they are rather than splitting their shares.
New Record-Keeping Challenges
Over time, stock splits create record-keeping challenges for company accountants, analysts and shareholders. A typical historical chart shows how a share price rises and falls over time. When you split a stock, the chart would naturally reflect the quick drop in share price. This doesn't offer a fair assessment of the stock's value, however, since it was a split and not market conditions that changed the price.
Fortunately, advanced software tools make it easier for companies and investors to show split adjustments on charts and in records. More advanced record-keeping tools come at a greater cost, however, and require more advanced knowledge to use.
Low Price Risks
Normally, companies split stocks when things are going well and the share price is on the rise. However, an overly aggressive split may lead to risks if the share price falls too much going forward.
A company whose share price grows from $5 per share to $20 in two years may decide to do a 2-for-1 split; this puts each share at $10. If the economy and company fall on hard times, however, the share price could drop below $5. This makes it less attractive to large buyers and mutual funds. If the share price falls below $1, it could face delisting warnings from NASDAQ or the New York Stock Exchange.
More Costs Incurred
For the company, splitting a stock is not free. The process of splitting a stock requires bankers and record keepers to update electronic shareholder records. The company must also meet listing exchange and legal requirements by letting shareholders know in advance when the stock will split and what impact the split will have. Writing notification letters and mailing them out to all shareholders gets pricey for companies with a lot of owners.
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