Tesla just announced plans for a 3:1 stock split in its annual proxy statement. The last time Tesla split its stock was on August 31, 2020 when it did a 5:1 stock split. Tesla’s announcement comes just after Amazon announced a massive 20:1 stock split in March 2022 as well as a $10 billion stock buyback plan.
If you don’t own any shares of Tesla or Amazon, chances are that you too will experience a stock split if you invest in a growing company over a long period. But what exactly is a stock split and how does it impact your cost basis, which is used to calculate capital gains taxes?
What is a stock split?
There are two types of stock splits: forward and reverse. The most common is a forward split, where a company splits its stock into smaller pieces. Stock splits are purely cosmetic and have no effect on the value of the company. Splits are denoted in ratios. For example, a two for one split is shown as 2:1.
Assume you own 100 shares of Tesla (TSLA) stock at the current price of $650. The total value of your Tesla holding is $65,000 (100 shares times $650). If the Tesla 3:1 stock split is approved, you will receive 3 shares for each 1 share of Tesla you own. As a result, you will now own 300 shares and the stock price will be divided by 3 to equal $216.67. Hence, your total Tesla holdings will remain the same at $65,000 (300 shares times $216.67). The price per share will be lower, but now you will have more Tesla shares giving you more options to diversify, sell, or make other investment decisions.
Just as a stock dividend has three (3) dates to remember, a stock split also has the same three dates: the date of record, the split date, the and ex-date. For example, Apple split its stock in 2020, the date of record was August 24, 2020; the split date was August 28, 2020; and the ex-date was August 31, 2020. Click here to read our article on each of the three dates.
As you can see, a stock split does not affect the total value of your investment, but rather simply gives you more shares with a lower price per share. Imagine you had a cake and you cut it into four pieces for your guests. The size of the cake doesn’t change if you now have more guests and decide to cut the cake into eight pieces instead. A stock split works the same way.
Why do companies split their stock? And, is a stock split good or bad for investors?
Companies declare stock splits for a variety of reasons, but mostly because an excessively high stock price creates a barrier to entry for most people to buy the stock. Research shows that people who own a company’s stock tend to be more loyal to the brand as consumers.
For example, even if you own 1 share of Starbucks (SBUX), you would most likely choose Starbucks over a competitor when buying coffee. Therefore, making your stock accessible to a broader audience is in the company’s best interest. Companies like Apple (AAPL) and Nike (NKE) recognize the psychological power of a larger shareholder base and have split their stocks many times, including a monster 7:1 split by Apple in 2014.
In addition, a high-priced stock makes diversifying difficult. You don’t want to have too much of your portfolio tied up in the fortunes of just one company. For example, the price of Amazon (AMZN) before its 20:1 split was $2,447. If you wanted to buy just 10 shares, it would cost you over $24,000. In a $100,000 portfolio, your Amazon holdings would be over 24 percent, which is a high concentration. Amazon’s current price of $106 makes it much easier to add to a smaller portfolio and still be diversified.
Why do companies not split their stock?
With the exception of a few online brokers that allow you to purchase fractional shares (at a hefty cost), most investors buy whole shares of a company and usually in increments of 100. Increments less than 100 are considered odd lot shares. The term is relevant because fewer shares make it hard to rebalance and manage risk in a portfolio, since you cannot trade fractional shares of a stock.
Some companies prefer not to split their stock. For instance, Warren Buffett’s Berkshire Hathaway (BRK-A), has never split its stock, which is why each share is currently $403,150, far too costly for most investors to buy 1 share let alone 100 shares. If you owned 1 share of Berkshire Hathaway, you could not diversify your holding without selling your entire position. Why does Warren Buffett not split Berkshire Hathaway? It’s because he wants to create a high barrier to entry to ensure whoever is buying his stock is a serious long-term investor and not a speculator trying to day trade.
What is a reverse stock split?
What about reverse splits? On March 21, 2011, Citigroup (C) did a 10:1 reverse stock split; in that case, if you owned 100 shares of Citigroup at $4.50 per share, you would then own 10 shares at $45 per share. Your total value wouldn’t change, you would just own less shares. Reverse splits are usually a sign that a company is in trouble, and you should think about selling your shares if this happens. A reverse stock split, while rare, usually occurs when a company’s stock price is too low or and the company wants to artificially boost the stock price to remain listed on an exchange.
Reverse stock splits are rarely beneficial for shareholders because the stock price starts off at a higher price and you have fewer shares, making it more difficult to re-balance your portfolio. In all likelihood, the stock price will continue to decline after a reverse split. In Citigroup’s case, the stock continued to decline after the split and has yet to recover.
How does a stock split change your cost basis?
The cost basis of a stock is used to calculate your capital gain. A forward stock split reduces your cost basis per share, but not your total cost basis.
Example: If you own shares in a growing company, such as Nike (NKE), for a long period, you are likely to see several splits over the years. Let’s assume you invested $5,000 in Nike stock 10 years ago and bought 100 shares at $50. Let’s also assume that the price of Nike stock is now $120 so the value of your Nike holdings is $12,000. If Nike declares a 2:1 forward split, you then own 200 shares at $60 per share. The value of your investment is still $12,000. Your total cost basis remains $5,000 because that is how much you paid for your shares, but your cost per share declines to $25 ($5,000 divided by 200 shares).
Lastly, remember to factor in your transaction costs when calculating your cost basis. For instance, if you buy 100 shares of Nike at $50 a share and pay $10 in commission, your cost basis per share is actually $50.10 a share [($50 x 100) + $10) / 100]. The reverse is true for net proceeds – if you sell 100 shares of Nike at $50 a share and pay $10 in commission, your net proceeds for tax purposes is actually $4,990. Of course most brokerage firms now offer commission-free trading (at a hidden cost), but professional traders still pay commissions to get the best price per share.
Looking for an independent fiduciary financial advisor who can advise you on investments, retirement, real estate, alternative assets, and taxes? Contact ACap Advisors & Accountants to schedule a free initial consultation. Our clients include individuals, small businesses, entrepreneurs, and anyone serious about saving and investing for their future.
Ara Oghoorian, CFA, CFP, CPA is the founder and president of ACap Advisors & Accountants in Los Angeles, CA.
*Post Updated on June 19, 2022*
