Stock Splits: A Closer Look At Its Effects

For investors in a company, it can be pretty exciting to hear that a stock you own is about to be split, as it indicates the company’s value has outgrown its share price. While it doesn’t actually make your investment any more valuable in and of itself, new investors may be attracted to the new lower share prices and bid them up. However, sometimes that initial feeling of pride that a company split its stock is followed by one of confusion as investors wonder how the stock split affects things like outstanding market orders, dividend payouts, and even capital gains taxes.

The good news is that, in the electronic age, most of the necessary adjustments are made for you. Still, it’s a good idea to understand how a split works and how it can impact – or not impact – your investment strategy.

Stock Splits 101

Typically, the underlying reason for a stock split is that the company’s share price is beginning to look expensive. Say, XYZ Bank was selling for $50 a share a couple of years ago but has risen to $100. Its investors, no doubt, are pretty happy.

But suppose that other stocks in the financial sector are trading well below this figure. Those other equities aren’t necessarily a better value, but casual investors sometimes make that assumption. To quell this reaction, companies will consider issuing new shares, which diminish the stock price by a proportional amount.

If XYZ Bank announces a 2:1 stock split (also coined a 2-for-1 split), it gives investors one additional share for each share they already own. Now, each one is now worth $50 instead of $100. The split may elicit additional interest in the company’s stock, but on paper, the investor is no better or worse off than s/he was before since the market value of his/her total holdings stays the same.

Advanced Trading Strategies

For most trading activity, the effect of a stock split is pretty straightforward. But naturally, investors with more complicated positions in the stock – for instance, if they’re short-selling it or trading options – may wonder how the split affects these outstanding transactions. If this is you, take a deep breath. In both these cases, your trades are adjusted in a way that neutralizes the impact on your investment.

Selling Short

First, let’s look at short-selling, a strategy in which the investor is betting that the stock price will decline. Basically, the investor borrows shares through his/her brokerage account and agrees to replace them back at a later date. She immediately sells the stock on the secondary market, hoping that s/he’ll be able to buy the same number of shares at a lower price before the loan comes due.

On the surface, a stock split might seem like a stroke of great luck for the short-seller. If you’ve sold 200 XYZ shares at $100 each, you can now acquire them at just $50, right? Unfortunately for short-sellers, it’s not that simple. The brokerage will adjust your order so that you’ll owe twice as many shares. When all is said and done, the stock split doesn’t affect your position one way or the other.

Options Contracts

The same is also true of options, which give holders the right to buy or sell a stock at a pre-determined price within a certain period of time. If you own an XYZ call option with a strike price of $80 – meaning you have the right to purchase the stock at that price – the split doesn’t mean you’re suddenly “out of the money.” The Options Clearing Corporation automatically adjusts the contract to include twice as many shares – in this case, 200 instead of 100 – and a reduced strike price of $40, putting you back “in the money”. Again, the investor comes out even.

Cancelation of Stop Orders

One area where stock splits can have an impact is a stop order. Such orders instruct the broker to sell a stock if the price goes above or below a given level. Often, people use a stop order to protect against significant losses, especially in cases where they can’t, or don’t intend to, monitor the stock price regularly.

Don’t assume your brokerage house will adjust the trigger price following a stock split. In most cases, the stop order is simply voided. Therefore, you’ll have to place a new order with the broker if you’re still interested in protecting your investment.

Eligibility for Dividends

One of the common questions that investors have after a stock split is whether their new shares are eligible for dividends. Unfortunately, this usually isn’t the case. Only shares held as of the dividend’s date of record qualify for dividend payouts. In other words, if the split occurs just after the date of record, investors shouldn’t buy the stock in the hopes of getting a check in the mail.

As for situations when the stock split occurs before a dividend record date, the dividend will for the most part be paid out for the newly created shares as well, except that the dividend likely will be split compared to previous time periods. This is due to the fact that companies want to maintain the amount of dividends issued. The dividend payout ratio of a company reveals the percentage of net income or earnings paid out to shareholders in dividends.

If before the 2:1 split, XYZ Bank’s target payout ratio is 20% of $100 million in earnings, that means its target dividend payout to shareholders in total is $20 million. If XYZ has 10 million shares outstanding, its dividend per share is $2 per share ($20 million total dividend payout ÷ 10 million shares outstanding). After the split, the company would have 20 million shares outstanding. Per share dividends would therefore be $1 ($20 million total dividend payout ÷ 20 million shares outstanding). You can see that the total dividend payout made by XYZ to its shareholders didn’t change at $20 million, but the per share value decreased due to the increase in the number of shares outstanding.

In reality, most companies avoid announcing a stock split close to the date of record in order to avoid any confusion.

Calculating Capital Gains

Figuring out how much capital gains tax you owe can be a pain as it is, and stock splits don’t make it any easier.

Investors will have to adjust their cost basis – that is, the cost of the shares they own – to accurately calculate their profit or loss.

If you owned XYZ Bank stock prior to its 2:1 split, your basis for each of those original shares is now $50, not $100. Otherwise, it may look like you’re trying to hide profit on your tax form – never a good idea.

Keep in mind that you may not sell your stock for several years after a split, so it doesn’t hurt to do a little research and figure out if your shares were sliced up at any point after the initial purchase. Of course, you’ll want to adjust your basis each and every time the stock was split.

New Stock Certificates?

While you may have paper stock certificates for the original shares you purchased, don’t necessarily wait for new ones to appear in the mail following a stock split. More companies are now issuing new shares in book-entry form (i.e. electronically) rather than the old-fashioned way.

To figure out how a particular company handles this, it’s worthwhile checking out the Investor Relations section of its website. Either way, don’t destroy those original paper certificates – they’re still valid.

The Bottom Line

In most cases, either the company itself or your investment brokerage will automatically adjust your trades to reflect the new price of a stock that has split. Still, investors should do themselves a favor by taking extra care when figuring out their tax basis and by re-submitting any stop orders placed prior to the split.