Everything You Need to Know About Stock Splits (and Reverse Stock Splits)

In the nearly 30 years since Amazon launched as a humble online bookstore, it has moved into just about every aspect of our lives. It’s now a retailer, a grocery store, a media streamer, a movie production company, a cloud computing company, a major employer, and just about everything else. All this expansion has led to a market capitalisation (the value of all shares of its stock) of about $US1.6 trillion, making Amazon the fifth-most valuable company in the world (after Apple, Saudi Arabian Oil, Microsoft, and Google). That’s a lot of money, and if you picked up some Amazon stock twenty years ago you are a very happy (and pretty rich) person right now.

This is why Amazon’s recent announcement of a 20-for-1 stock split made big headlines. If you’re one of those people whose knowledge of stocks and the stock market begins and ends at “it’s complicated” and the current, largely mysterious value of your 401k fund, you might wonder why it made headlines. Why should anyone care, and what does a “stock split” mean, anyway?

The difference between a stock split and a reverse stock split

Stock splits are actually pretty simple concepts. When a company splits its stock, it increases the number of shares, reducing each individual share’s value by a proportional amount. If your company was split into ten stocks, each worth $1, you could split it into 20 stocks, each worth $0.50. The total collective value of the stocks doesn’t change, it just creates more of them; if you owned two shares worth $2 before, you now own four shares that are still worth $2.

A reverse stock split is the same thing backward: A company reduces the number of its shares, increasing the individual value of each share without changing the overall value of the company. So if you had 20 stocks at $0.50 each and reverse-split them to 10, each share would be worth $1.

Typically, stock splits happen in relatively small ratios — 2-for-1 and 3-for-1 are the most common. That’s one reason why Amazon’s 20-for-1 move made headlines — it’s unusually aggressive. It’s also combining the move with a $US10 billion stock buyback, which will boost the new stock value slightly.

Why split stocks?

Companies will split their stock when the share price gets too high. Investors prefer to buy stocks in bundles, or “lots,” of 100 shares. If an individual stock gets too expensive, smaller investors simply can’t afford to buy them. Amazon is a great example: Its stock has been priced close to $US3,000 ($4,165) for a while now, which is just hella expensive. A standard 100-lot purchase would run you $US300,000 ($416,460) plus fees, which is simply beyond a lot of investors’ reach. After the 20-for-1 split goes into effect this summer, the price of each share will be around $US150 ($208) (depending on the actual valuation when the time comes). That suddenly makes a 100-share lot cost a more accessible $US15,000 ($20,823).

This can make the stock more attractive to stock market indexes like the Dow Jones Industrial Average, which uses 30 “prominent” companies to track the health of the stock market in general. Since the DJIA is price-weighted (meaning the more expensive its stock, the more influence it has on the direction of the index), Amazon wouldn’t be included at a $US3,000 ($4,165) stock price — but at $US150 ($208) it’s a candidate. Splitting the stock also makes the stock more liquid, meaning it’s easier to cash out, which also increases its attractiveness to investors. After all, if your stock is so expensive you can’t easily or quickly sell it when you need actual cash, it’s not actually as useful an asset as you’d like it to be.

Splitting its stock will also make it easier for Amazon to offer stock options to its employees. A sky-high stock price makes it hard to offer modest grants in the $US5,000 ($6,941) to $US10,000 ($14,000) range. A lower share price offers more flexibility.

A reverse stock split, again, is applied for the opposite effect: If a company feels its shares are getting too cheap (risking delisting from an exchange, for example), a reverse-split instantly makes individual stocks worth more. There’s also a manoeuvre called a reverse/forward stock split in which a company first reverse-splits their stock — which forces some stockholders with very small positions to sell their shares — then does a standard stock split to return to the previous stock price, increasing the shares owned by the other shareholders. It’s a way of forcing consolidation.

Stock splits in either direction are just straightforward management techniques — no one is really losing or gaining anything in the moment, but the way the stock is perceived and handled changes going forward. Is this a good time to buy Amazon stock? Maybe — but that’s a question for your broker.