Listed companies have the option of reacting when share prices rise sharply. In this case, a stock split is carried out. While this measure usually brings advantages for stock corporations, it can be disadvantageous for investors. This guide provides you with all the important information on the stock split and what details are important.
What is a stock split?
A stock split is a measure taken by stock corporations in which shares are divided in a certain ratio. In this way, existing shares are converted into a larger number of new shares with a lower nominal value.
However, the larger number of shares does not change the stock market value of the issuing company – only the issued number of securities changes. In English, the stock split is called a “forward stock split.”
Reasons for the stock split
When a company is successfully listed on the stock exchange, its share price increases. At the same time, the high price value of the share becomes increasingly unattractive for a broader group of investors, as they have to raise significantly more capital to invest in the company.
The stock split reduces the par value of the shares and makes the securities visually more favorable for investors. Companies hope that this measure will lead to greater demand for their shares and thus to a rising share price and a growing stock market value.
In the medium to long term, a stock split can thus be a means of increasing a company’s share price, even if the nominal value is initially reduced.
Requirements and timing
Whether or not a stock split may be carried out must be decided by a simple majority of the shareholders at the Annual General Meeting. A stock split is not possible without a resolution by the Annual General Meeting.
How can investors recognize a stock split?
As a rule, shareholders are informed at the latest at the Annual General Meeting that a stock split is planned. Since the share charts and the historical price data are adjusted immediately after a split has taken place, the split is often not immediately recognizable.
Only the significantly lower par value shows that a split has taken place. If investors then check their portfolio and find that the par value has changed but their portfolio value has not, a split has probably taken place.
Companies are interested in providing detailed information about a split of their securities. Otherwise, panicked investor behavior could lead to corporate losses. For example, investors might sell their securities immediately because, in their eyes, prices have fallen rapidly for no apparent reason. These sales would then add significantly to the share price of the split stock.
What can happen without a stock split
If a company avoids a stock split, it may cause the stock to become increasingly unattractive to a broad class of investors without a capital increase. As a result of falling demand, the company’s share value would decline in the long term.
An impressive example of such a share that has never been split is the security of the holding company of the major American investor Warren Buffet. The market value per share was at times more than 200,000 euros.
Implementation of the stock split
Each stock split must first be resolved by the Annual General Meeting of the stock corporation. A simple majority is sufficient for this. Following the resolution, the old shares are exchanged for the new shares in a specified ratio.
In the case of no-par-value shares, an amendment to the Articles of Association is made for the split, as each shareholder has a fixed share in the company, with no par value. In the case of par value shares, the stock split is implemented by withdrawing the old shares and issuing the new shares with the same WKN and ISIN.
By using so-called “global shares”, in which many par value shares are bundled, the change in the case of a stock split is even easier to implement and requires less administration.
Share value does not change for the time being
In the case of a stock split, only the number of shares changes; the equity capital of the AG and the share value of the investor do not change for the time being. For this reason, a stock split is usually referred to as a “psychological” effect and not as a direct economic effect.
Ratio of the split
The ratio in which the shares are split is left up to the stock corporations themselves. In a 1:10 split, a shareholder would receive ten new shares for one old share.
Automatic cancellation of stop-loss orders
With a stop-loss order, investors can opt to automatically sell shares when they fall below a certain price. Since the share price drops enormously due to the stock split, this would result in an extreme sale of shares, which would cause dramatic price losses for the company.
To prevent such a scenario, stop-loss orders are automatically deleted before a stock split. How brokers or banks handle stop-loss orders in the event of a stock split can be found in the respective terms and conditions.
Effects on certificates
When a stock split is carried out, it also affects all related certificates. These are derivatives such as warrants. These are adjusted in accordance with the splitting ratio. For this purpose, a so-called “R-value” is calculated. This factor consists of dividing the number of old shares by the number of new shares. For a stock split of 1:5, the R-value would be 0.2. All the strike prices of the certificates are now multiplied by this R-value, while the subscription ratio of the derivatives is divided by the R-factor.
It is important to note that the R-value is also applied to caps or ceilings.
Example of stock splits
One of the most famous examples of a stock split was the Google stock split in 2014. The company’s shares have been steadily rising on the stock market, making the securities attractive enough for fewer and fewer investors to take a stake in the company.
At times, the market value of the shares was more than $1,200. Finally, the U.S. company decided to split its shares. However, this resulted in an A share becoming a C share. The German tax authorities interpreted this change in the shares as a dividend in kind and levied capital gains tax on the shares.
Some investors lost almost 30 percent of their share value in this way, without having realized any income from the stock split. To this day, investors have been waiting for a refund of the taxes they paid unnecessarily.
Advantages and disadvantages for investors
A stock split does not initially result in any advantages or disadvantages for the investor. He merely has more shares in a company than before, but the portfolio value initially remains the same. Afterwards, it depends on whether demand for the shares at the lower nominal value increases. In this way, the price of the shares held and thus the securities account value can increase.
However, if many investors decide to sell after a split, the price may fall in the short term and reduce the investor’s securities account value. An ill-considered stock split can also lead to a price collapse. As a rule, such a development is rarely possible, as the issuing stock corporation itself is interested in the share price rising again in the long term.
Stock split or capital increase
To attract new investors and investors, companies can also carry out a capital increase instead of a stock split. In this case, new shares are issued in the form of stock.
For the company, both the stock split and the capital increase mean fresh capital with which to invest. In the case of a stock split, it is likely to take longer for the more favorable share prices to generate increased demand.
For investors, a capital increase can be disadvantageous because it initially reduces their own company shares. As a rule, stock corporations preferentially offer new securities to their shareholders so that they can retain their shares by buying new ones.
In 2005, for example, the software company SAP carried out a capital increase from company funds in order to avoid diluting the company’s shares for investors.
A stock split has no tax implications, as the capital invested and the capital gains from it remain the same. Only the number of shares changes. Investors do not have to fear any tax consequences as long as the ISIN and WKN remain the same.
However, investors should be careful if the stock split involves a change in the share. If, for example, the security identification number and the ISIN change, the tax authorities may recognize this change as a dividend in kind and levy withholding tax on the new shares. However, this practice has been corrected since the Google stock split case in 2014. In theory, investors in this case can claim back the overpaid taxes. In practice, however, there has not yet been a refund from the German tax authorities.
Reverse split – the opposite of the stock split
In a so-called “reverse split”, the exact opposite of a stock split takes place. When a reverse split is carried out, the issuing company combines its shares. The consolidation takes place at a previously defined ratio, for example 10:1, in which case shareholders receive only one share for ten shares.
The stock split is also known as a reverse stock split or par value increase, and in English as a “stock splitdown”.
Purpose of the increase in par value
By combining shares, the par value of the shares is increased. In this way, a share price can appear more expensive. At the same time, a company can actually make its shares more valuable if the share price on the stock exchange falls below the par value.
In this case, the company in question would not be able to increase its capital. The German Stock Corporation Act prohibits the issue of new shares if the price of existing securities is below par.
If a company cannot obtain fresh capital via the stock exchange, it may experience financial difficulties or have to postpone investments. The reverse split is thus an aid to further capital preservation via the stock exchange.
How a reverse split works
In a reverse split, all existing shares are cancelled. Afterwards, these shares are replaced by the new shares with increased nominal value. The security identification number (WKN) as well as the ISIN remain unchanged.
This method is used when the stock market price of a company is to be increased. The number of shares is reduced in this case, but the reverse stock split does not affect the value of these shares. The share capital as well as the total capital of the company remain the same.
After the reverse stock split has been carried out, the share price charts are automatically adjusted accordingly. This prevents investors from making incorrect interpretations as a result of the increase in the nominal value.