Chances are, if you invest in a growing company over a long period, you will experience a stock split. But what exactly is a stock split and how does it impact your cost basis, which is used to calculate capital gains taxes?
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. Splits are denoted in ratios. For example, a two for one split is shown as 2:1. For example, if you have 100 shares of Intel (INTC) stock, worth $100 a share, you get 200 shares worth $50 each in a 2:1 stock split.
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.
Companies declare splitsfor a variety of reasons, but mostly because an excessively high 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 it as consumers. Therefore, making your stock accessible to a broader audience is in the company’s interest.
Also, 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 Apple (AAPL) stock, at the time of writing this post, is $583. If someone wants to purchase 10 shares, they have to spend nearly $6,000 on just one stock. If their entire portfolio is $10,000, the Apple stock represents 60% of the total, which is not a diversified portfolio.
In addition, fewer numbers of shares make it hard to rebalance and manage risk in a portfolio, since you cannot trade fractional shares of a stock. Some companies, like Warren Buffett’s Berkshire Hathaway (BRK-A), have never split their stock, which is why each share currently is $132,160, far too costly for most investors.
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 rebalance 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? That’s the purchase price, used to calculate your capital gain? The cost basis of your assets is adjusted for splits. A 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, but your cost per share becomes $25 ($5,000 divided by 200 shares).
Regardless of whether your stock splits, 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. 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.