Stock splits happen from time to time for a variety of reasons. While some companies use them to increase the number of shares available to investors and reduce the price per share, others do the opposite. How do splits affect share valuations and is it wise to sell before a stock split?
Do not sell a stock before a split. Unless you have strong underlying reasons to do so. In a forward split, the shares of a performing stock can become more valuable as new investors drive prices higher. In a reverse split, the new share price can also make stocks look more valuable to buyers and avoid delistings.
In this article, you’ll learn how stock splits work and what the best approach is after a stock split is announced.
What Is a Stock Split?
In a stock split, a company multiplies or divides its outstanding share count to achieve a specific goal. The split only changes the share count and price for a single stock, but it doesn’t affect the market value or capitalization for a stock.
A stock split can either be a forward split or a reverse split.
A forward split is the most common type of stock split. Here, the company divides each share into two, three, four, or more. If a company with a share price of $100 splits its shares by five, it’s called a 5-for-1 split.
All owners of shares in the company will have their share count multiplied by five, but the overall value will stay the same. In the example above, that $100 share will become five $20 shares.
The share count increases, the price per share drops, but the value remains the same.
Companies rely on forward splits to make their shares more affordable and attractive to would-be investors. A share price of $100 is psychologically harder for smaller investors to add to their portfolio than a share price of $20.
The same applies to shares in the thousands. Therefore, companies use stock splits to ensure their stocks don’t look too expensive at face value and also put more units on the market for investors.
Reverse stock splits are the opposite of the forward split. Shares owned by investors are reduced multiple times to achieve a smaller number for the same value. So, let’s assume you own 30 shares of a company’s stock worth $3 per share, and they implement a 1-for-5 reverse split.
The value of your holdings is $90 for the 30 shares. After the reverse split, you’ll have six shares worth $15 each. The value of your holdings remains the same, but the price per share is now higher.
Companies use reverse splits to make their share price look better on paper. There may also be some regulatory demands that have to be met. For instance, shares listed in the New York Stock Exchange must be higher than $1 to remain listed.
So a company with their share price about to dip below that threshold will use reverse splits to avoid delisting.
Should You Sell a Stock Before Forward and Reverse Splits?
It’s not a good idea to sell a stock before forward and reverse splits just because of the split announcement. It’s important to look at the underlying fundamentals that have caused the split decision before choosing to sell or to continue holding.
Selling Before a Forward Split
Investors who trade micro stocks recommend selling a stock before a forward split. Popular trader Thomas Bulkowski is one of those. He noted in this post that stocks typically outperform the market by 3% before the split and go static after. He also mentioned that 54% of the stocks declined three months after the split.
Looking at those numbers, the conclusion is that it’s a good idea to sell stocks before forward splits to lock in a modest profit. However, this is only good advice for active stock traders. Do you want to go through the process of selling shares you bought with a long-term view in mind to lock in some profit and probably avoid a small drawdown?
Renowned economist David Ikenberry countered the above view in his research. He noted that stocks outperformed the market by 8% one year after a forward split and 12% after three years.
So, any short-term gains achieved by selling a stock before the split date will most likely be smaller than the gains achieved by holding the stock through the split and beyond.
Tesla is a real-world example of how it often pays more to hold a stock through a forward split. After announcing their last split in August 2020, the share price jumped more than 70% before the split date. By the end of the split date, the share price was $498.
Today, the share price is $759. It means that if you sold the share on the split date, you’d have missed out on a further 52% return in 12-months.
Apple’s story is also well documented. A forward split often shows that a company has become very valuable and popular to investors. The Ikenberry research shows that forward split stocks outperformed the market before the split and will likely continue in that trajectory after the split.
A forward split makes a performing stock more affordable, leading to a stronger long-term performance.
Therefore, you should only sell before such a forward split if you no longer believe in the company’s valuation or you think it’s in some sort of a bubble. Otherwise, you should hold on to the stock before and after the split.
Forward Split and Fundamentals
When looking at forward splits its imperative that you keep on eye on fundamentals, many stocks like the aforementioned Tesla will go higher, but that doesn’t always mean they are a good buy. The hype generated can drive prices higher, but during market downturns they tend to fall much harder.
This is why its often best to take profits along the way. Generally some time after the split as hype has dies down.
Selling Before a Reverse Split
Many analysts agree that a reverse split is typically a red flag and a sign to sell the stock. On paper, this is true. A 2008 study of reverse stock splits in the 40 years between 1962 and 2001 shows that there’s often a significant share price drawdown in the three years following such a split.
As mentioned above, a company may initiate a reverse split to stay listed on an exchange. They may also use the split to correct a negative perception of the company caused by their low share price. Both scenarios are signs of a company that isn’t performing well, and you’d be right to sell in most cases, especially keeping the reverse split study report in mind.
However, if the reverse split is accompanied by significant changes in the company that can improve operations, enhance projected earnings, and improve other key metrics that are important to investors, the stock may consolidate at the higher share price after the split and may rise further from there.
I target these types of stocks in my net net portfolio and often many of them have performed reverse splits.
When the company operations don’t change much after the reverse split, the reasons for the low share price will likely drag down the stock price from its news higher valuation.
So, before you decide to sell a stock after a reverse split, you should look at other underlying fundamental indicators. If there’s some promise, it may be better to hold the stock instead of selling.
Citi Group Example
A good example of how reverse stock splits can work for companies in the much-publicized case of Citigroup. In 2011, the company initiated a 1-for-10 reverse split which took its share price from $4 to around $40. The stock price has bounced around a bit in the last decade, but it’s currently trading at around 75% higher than the split price.
They announced the split after reporting their first year of four profitable quarters in 2010. It highlights how the reverse split backed by solid fundamentals can make a difference. Investors who interpreted the reverse split as a sell signal without other considerations have missed out on the returns.
Japanese Reverse Splits
Most of the companies in my net net portfolio are Japanese companies. Around 2017 many of them performed reverse splits for a seemingly monotonous reason.
Companies in Japan sell in lots of 100, but used to sell for 1000. This meant you had to buy 1000 shares before you could own a piece of the company. When they were forced to sell in lots of 100, many companies performed 10 to 1 reverse splits to raise the price per share to keep it equal to its previous investor hurdle.
To Sell or Not To Sell: How To Decide
We’ve seen that forward splits are generally good news and reverse splits are typically red flags. However, we’ve also seen that there’s always room for exceptions. So, you need to think carefully about your decision.
The best way to decide if you should sell a stock before a split is to look at the company’s trajectory leading up to the split announcement. Is the business flourishing? Are there any immediate bottlenecks to their operations? Are they likely to be hit by policy changes in the near-to-medium term?
Answering these questions will show you a company’s prospects. If you can’t decide or don’t have access to key data and reports that can influence your decision, don’t hesitate to consult your financial advisor. In the meantime be sure to check back here and look for tips to improving your small investor advantage.
Selling a stock before a split isn’t always the smart thing to do. For forward splits, you may end up missing out on momentum and continuation rallies. Companies implementing forward-splits have stocks that have a high demand in the market. They don’t become less valuable after the split. So, selling will almost likely mean lost ROI.
On the other hand, companies implementing reverse splits are less healthy. You’re likely to benefit more from selling such stocks and avoiding a possible drawdown—but only if the company isn’t already showing healthy underlying fundamentals.