Written by: Emeka Nwankwo

This topic is trending in the news again so there is no better time for a refresher. Let’s start with some basics, a stock is a financial instrument that represents a proportion of ownership or equity in a company. There are 2 types of stock – Common and Preferred stock. Common stock provides an entitlement to profits and voting rights whilst Preferred stock provides a guaranteed fixed return with no voting privileges. The difference between both is also highlighted in the event of a company’s liquidation with preferred stock owners taking precedence in the hierarchy of repayments. The type or class of stock is typically determined by corporate charter and can found in a company’s prospectus. Common Stock can also be different classes. The factors determining the class could be voting, redemption and dividend rights to name a few. Most of the time, the class of stock being discussed or referenced in the news, media outlets or financial publications are Class A shares (common stock). Class A shares usually come with entitlements to dividends, voting and ultimately profits. The scope of this article will be limited to Class A shares alone.

A company’s stock price is useful in terms of the broader analysis of valuation. A company’s value can be derived by multiplying the price of its stock by the number of shares issued. For example, ABC Inc has 1 million shares in existence with each share priced at $10. Therefore, ABC Inc as a company can be described as being valued at $10 million.  This valuation is referred to as ABC’s Market Capitalisation. Naturally, there are several ways to determine the value of a company Discounted Cash Flow (estimating future cash flows and applying a discount rate to account for the time value), Asset Based (assessing the assets held by the company), Earnings Multiple (using the earnings of a company as a base and applying a suitable multiple) and Market Capitalisation is one of them. Value is in the eyes of the beholder and is very subjective.

The price of a stock is governed by the fundamental economic law of demand and supply. The higher the demand the higher the price, the lower the supply the higher the price and vice versa. It is irresponsible to make this statement without the caveat ceteris paribus – latin for ‘all things being equal’. Demand and supply is driven by internal and external factors such as first and foremost company performance, perception of management, technological advancements, overall economic conditions e.t.c. A surge in demand for a stock can lead the price to levels that seem undesirable to Senior Management of a company which is when they opt for a Stock Split. The term describes the process exactly, the stock is divided into smaller parts according to a specified ratio and in effect more shares are added to the market. Remembering the laws of demand and supply, this increase in the number of shares issued (supply) has a dilution effect and invariably leads to a reduction in the stock price at least in the immediate term. Reality and theory rarely match entirely in social sciences because of the irrationality of human behaviour. There is a thought that stock splits actually create a slight increase in stock prices (post split) but we will get to that later. For now the fundamental concept is companies undertake stock splits to reduce stock prices. The mathematics for this is very basic. Let’s go back to ABC as an illustration:

Management in ABC, decide $10 is too high a stock price and want to see that price halve. They make the decision to split the stock at a ratio of 2:1 or 2 for 1. At the end of the split each investor or share holder will have an additional share for each share they already hold.

BEFORE STOCK SPLIT

1 million shares @ $10 = $10 million valuation (market cap)

AFTER STOCK SPLIT OF 2:1

2 million shares @ $5 = $10 million valuation (market cap)

The valuation of the company remains the same with the only changes being the number of shares in issuance and consequently the price. If you held $10,000 worth of ABC stock before the split you would have had a 1,000 shares (priced at $10). Post split, you now have 2,000 shares (priced at $5) with the value remaining at $10,000.

The entire purpose of a stock split is to achieve a reduction in the stock price. Most of the reasoning behind this is similar to why concepts such as Charm or Psychological pricing exist. Even though an assessment from a value perspective would yield the same result, there tends to be a psychological barrier for humans when it comes to ‘perceived’ high prices. Companies will normally cite wanting a wider variety of shareholders as motivation for a stock split on the premise that a lower price may entice participants who wouldn’t otherwise buy the stock. The recent NVIDIA stock split announcement conveyed this very sentiment. Management expressed the desire of making shares more affordable for employees. Sometimes there are options for fractional trading (i.e dealing with portions of a share rather than a whole unit) but these are not always available. Sometimes the decision on a stock split is more than just good will. The decision may also be made on the basis of aligning with the share price levels of similar companies. Usually, a successful stock split results in the share price trading at a higher level after the split and this is driven again by the perception of the company being better value (even though as we’ve shown valuation remains the same). Stock splits also tend to be a hallmark of success because a company’s management usually believe the split stock will continue to appreciate in price. The stock split announcement for NVIDIA alone moved the stock price from $950 past $1,0000 mark.

NVIDIA is in the spotlight with a steep rise in its valuation driven by demand for shares. The surge in demand for shares has been fueled by impressive performance as the company’s importance in the AI sphere grows. NVIDIA’s share price rose from just under $40 to $1,200 in the past 5 years with a valuation in excess of $3 trillion. On Monday 10th June it became the 4th in a group of 7 stocks dubbed the Magnificent 7 (Apple, Microsoft, Meta, Tesla, Amazon, Alphabet) to split its stock since 2022. Management at NVIDIA decided on a stock split at a ratio of 10:1. With a closing stock price of $1,208.88 on Friday, the pre trading stock price is $120.38 at the time of writing (10th June 24, 10:00 am GMT).

Another thing to bear in mind is some companies have had multiple stock splits throughout their history). Microsoft for example has had 9 stock splits in its history:

The 9 Microsoft stock splits means an original holding of 1,000 shares would be 288,000 shares today

Source: https://www.stocksplithistory.com/msft/?l=1

Finally, there is an option of achieving the reverse of a stock split and it is aptly named – a reverse stock split. This achieves the opposite of a stock split, i.e it serves to reduce the number of shares in issuance (supply); thus, increasing the stock price.  The mathematics also works in reverse, so a shareholder is left with fewer shares. Sometimes a company will undertake a reverse stock split to boost share price for fear of being delisted from an exchange or index. Stock exchanges or indices tend to have minimum price requirements to trade, the NASDAQ for example has a minimum price requirement of $1 and the FTSE 100 requires you to remain the top 100 companies by market cap.

Some great resources to enhance your learning are: