After the market closed on Friday, June 7, 2024, Nvidia (NSDQ: NVDA), a prominent player in the fields of graphics processing units (GPUs) and artificial intelligence (AI), completed a 10-for-1 stock split.

This move followed significant share price appreciation. Nvidia surged 210% during the past year and nearly 850% since November 2022. In this split, investors were given nine additional shares for each share they already owned. So, if you owned one Nvidia share, you would have ten shares after the split. However, the total value of your shares would remain the same as before the split.

Generally speaking, when there is a major stock split, pundits discuss whether these splits matter at all. I have also seen plenty of people misunderstand the nature of these splits. They might have felt that Nvidia at $1,000 a share is just too expensive, whereas Nvidia at $100 a share is cheap. I literally once had an investor tell me they wouldn’t pay $200 for shares of any company, because that’s too expensive. The reality is that one share of Nvidia at $1,000 is the same as 10 shares at $100/share.

In those practical terms, stock splits don’t matter. The total value of your shares is the same immediately before and after the split.

What Stock Splits Imply

However, there are some other considerations. Stocks usually split when the share price has appreciated significantly. Thus, they split when companies are doing well, and most continue to do well after they split. Thus, buying a company that is splitting can be a good strategy, because in theory you are buying a good company.

There have been several studies that confirm this. A 1996 study by David Ikenberry, Barbara Saunders, and Graeme Rankine published in the Journal of Finance, reinforced these findings. It showed that companies that split their stocks experienced positive abnormal returns of around 8% in the year following the split and continued to outperform the market by approximately 12% over the next three years.

A 2015 analysis by Hendrik Bessembinder, Eugene Kandel, and Amir Zeudner, published in the Review of Financial Studies, found that stock splits in the modern market continue to be associated with positive long-term abnormal returns. The study showed that, despite changes in market conditions and trading technologies, companies that split their stock still tend to outperform those that do not over the following three to five years.

Reverse Splits

The inverse has also been shown to be true. Stocks that undergo reverse splits tend to underperform the market. That’s because stocks do reverse splits to prop up a falling share price. For example, a stock trading at $1 may do a 10-1 reverse split to push the share price to $10. But historically a split like that would tend to see shares fall from that post-split price. ​

A 2002 study by Amy K. Edwards and Karpoff that appeared in the Journal of Corporate Finance, examined market reactions to reverse stock splits. It noted that these stocks tend to suffer from both immediate negative market reactions and long-term declines. The research highlighted that companies often employ reverse splits when facing significant financial distress, which can contribute to prolonged underperformance.

The Option Impact

In addition to what stock splits imply about how a company is doing, there is one way that stock splits significantly matter. If you trade options, one option represents 100 shares of stock. Thus, before the split, if Nvidia is trading at $1,000 a share, a single option contract on Nvidia represents $100,000 of stock.

For those interested in doing a covered call or in selling a cash-covered put on the company, that’s a significant outlay of cash. But after the split, and with shares trading at $100, the outlay for an option trade is only $10,000 per contract. Thus, a split increases the pool of investors who are able to do option trades on a company.

Final Thoughts

In conclusion, Nvidia’s recent 10-for-1 stock split underscores a broader trend. Companies, following significant share price appreciation may aim to enhance liquidity and make their stocks more accessible to a wider pool of investors. Such moves not only reflect robust performance but also align with historical data suggesting that stocks undergoing splits tend to outperform the market over the long term.

Conversely, reverse stock splits, often a marker of financial distress, typically signal potential challenges ahead, leading to underperformance. Therefore, while the intrinsic value of a stock doesn’t change immediately following a split, the implications for market sentiment and trading accessibility can significantly impact a company’s stock performance. Investors should consider these dynamics when evaluating the potential benefits and risks associated with stock splits and reverse splits.

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