The concept of a stock split often grabs headlines and attracts the interest of both seasoned investors and market newcomers.
Recently, the leading player in the tech industry, Nvidia, announced a forward stock split, making it the eighth company this year to take such a step, and this move, while it does not change the company’s market value, has significant implications for investors and the market at large.
Before we delve into why companies like Nvidia choose to enact them, and what it means for investors and the broader market, let’s understand what it is.
A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares. While the number of shares increases, the total value of the shares remains the same compared to pre-split amounts, meaning the split does not affect the company’s market capitalization.
For example, in a 2-for-1 stock split, every shareholder receives an additional share for each share they own, effectively doubling the number of shares while halving the price of each share. The company’s overall value remains unchanged, but the number of shares outstanding increases.
There are two main types of stock splits: forward stock splits and reverse stock splits.
The forward stock split is the most common type of stock split, and it consists of increasing the number of shares outstanding while reducing the price per share.
In the case of a reverse stock split, it reduces the number of shares outstanding by consolidating multiple shares into one, increasing the price per share.
For example, a company decides to enact a 1-for-5 reverse stock split. If you own 10 shares of this company’s stock, after the reverse split, you will own only 2 shares as you divide the 10 shares by 5. In addition, the price per share will increase accordingly, thus, if the price per share was $10 before the reverse split, it will become $50 after the split. This latter stock split is often used by companies looking to boost their share price to avoid delisting from stock exchanges that have minimum price requirements.
Now, why do companies enact forward stock splits?
Well, one of the main reasons is because a stock split tends increase the stock’s liquidity, and this is because a lower share price makes the stock more accessible to a broader range of investors, including retail investors who may find high-priced stocks unaffordable. Thus, this increased accessibility can lead to more trading volume and potentially more price stability.
In addition, due to the fact that many investors perceive a lower-priced stock as more attainable, even if the underlying value remains the same, there can be an increase in buying interest, which could then lead to a potential rise in the stock’s market price over time.
Also, it is worth noting that stock splits are often interpreted as a signal of a company’s confidence in its future growth prospects. According to an analysis by Bank of America, stocks that split have shown average returns of 25% one year later, compared to around 12% for the broader market. Thus, a company that enacts a stock split is typically performing well and expects continued positive performance, and this can attract more investors looking for promising opportunities.
Moreover, Bank of America’s analysis suggests that there are about 36 companies in the S&P 500 index with stock prices above $500 per share that are ripe for stock splits. These companies, with a combined market value of $7.4 trillion, could potentially benefit from increased liquidity and investor interest following a split.
Furthermore, there are eight companies within the S&P 500 with share prices exceeding $1,000 that are even more likely candidates for stock splits.
In terms of what stock splits mean for investors, as mentioned before, these splits can lead to lower prices, thus, these types of moves may lead to buying opportunities, especially for those retail investors who may have been unable to afford higher-priced shares. In addition, investors who invest during stock splits, can expect higher returns, and since the reasons behind a split are usually indicative of a positive outlook, the long term growth is also possible.
So, is it worth buying Nvidia’s stock before its stock split?
Well, investing decisions should be based on individual investment goals and risk tolerance, but it is worth remarking that there are three compelling reasons to consider buying Nvidia stock before its stock split:
- Nvidia’s data center division has been experiencing impressive growth, driven by the increasing demand for AI processing power. This trend is expected to continue, which indicates potential future revenue growth for the company.
- Despite its success, Nvidia’s stock is not as expensive as some other tech stocks when considering its forward earnings multiple. Thus, given the company’s strong growth prospects, the current valuation may present an opportunity for investors.
- Nvidia recently announced a significant increase in its dividend payout, signaling its commitment to returning capital to shareholders. Thus, while the current dividend yield is modest, the potential for future increases and a stronger payout could make the stock more attractive to income-seeking investors.
Nonetheless, despite this positive outlook , it is also very important to keep in mind that stock split announcements can sometimes lead to short-term run-ups in stock prices, which could impact the optimal timing for a purchase.
