What are “Stock Splits”?

A stock split is when a company divides its existing number of shares into multiple shares. For example, a 3-for-1 split would mean a shareholder who owns 1 share in a company will receive 3 shares after the stock split. Companies go in for stock splits to boost the liquidity of their shares and make them more affordable for investors.

Importantly, when a stock split is declared, the number of shares of that company increases. However, the market capitalization remains the same. While stock splits do not alter the underlying value per share, they can increase the buying and selling activity around a stock, making it more attractive to investors. For example, if a stock is trading at $500, it is possibly too expensive for many investors. However, with a 3-for-1 split, each stock will be worth around $167 which will make the shares more accessible to investors.

Key Learning Points

  • In a stock split, the existing issued stocks of a company are split
  • This increases the number of stocks, while the market value of each stock falls – keeping the total value of equity capital unchanged
  • Stock splits are used to lower the price of a stock, perhaps if it is too expensive vs. peers, and also to improve liquidity
  • Stock splits can be used to increase investor interest in a stock particularly if a stock has enjoyed a long period of strong growth
  • Analysts use a company’s number of shares outstanding to arrive at valuation metrics such as equity value, enterprise value, and other multiples so they need to adjust the shares outstanding to reflect the stock split.
  • Stock splits have an impact on the Earnings Per Share (EPS) of a company
  • A reverse stock split is the opposite of a stock split: the total number of shares are divided which increases the stock price accordingly

Stock Splits Explained:

Suppose a company has 500 shares outstanding, and each share is trading at $40, the equity value of this company will be $20,000.

Let us now assume that the company announces a 4-for-1 stock split.

After the split, its number of shares outstanding will increase to 2,000 (as mentioned above), while its share price will reduce to $10.The equity value remains unchanged at 20,000.

The Role of Stock Splits in Valuation:

When valuing a business, analysts use a company’s number of shares outstanding to arrive at various valuation metrics such as the equity value, the enterprise value, and other multiples such as LTM EBITDA multiple. Typically, the information on a company’s basic common shares outstanding is available in its latest published financial data. However, events such as stock splits can happen between the publishing date of common shares outstanding data and the valuation date.

As stated before stock splits increase the number of shares outstanding. Consequently, valuers need to adjust the number of common shares outstanding to reflect stock splits for the purpose of valuation.

Adjusting the Number of Shares Outstanding for Stock Splits:

Given below is an example of the impact of stock splits on valuation using the aforesaid example. Further, given below is some additional information on this company.

First, some valuation metrics using the post-split share price and the pre-split number of shares outstanding have been worked out. Given below is the equity value, enterprise value, and LTM EBITDA multiple for this company.

In this calculation, the key point to note is that while the share price has reduced to $10 from $40 due to the stock split, the number of shares has not increased. Consequently, the equity value is understated, thereby the EBITDA multiple is understated too.

Next, given below are the revised calculations, using the revised number of shares outstanding (i.e. 2,000).

Note that the enterprise value has increased to 105,000 (from 90,000 earlier) and the EBITDA multiple has risen significantly to 11.7x (from 10.x earlier.)

Stock Split Impact on Earnings Per Share (EPS)

Stock splits also have an impact on the earnings per share (EPS) of a company. In 2015 Netflix stated in June that the company had declared a seven-for-one stock split.

In 2014, the year before the stock split, the company had reported a Basic EPS of $4.44 (as stated above).

In 2015 (given below), the company’s Basic EPS reduced to $0.29 due to the stock split. Notice the increased number of shares outstanding has been used for calculating the EPS.

Next, most importantly, post stock splits, companies retroactively update the number of shares outstanding to ensure consistency in comparisons. In the case of Netflix, they had updated the information for 2014 in their 2015 annual report.

The number of shares outstanding used in 2014 calculations have been updated to 420,544 from 60,078 in the previous calculation. As a result, the Basic EPS of 0.63 for 2014 is consistent with that of 0.29 for 2015.