Research from the Journal of Banking and Finance shows that stock splits have historically had a positive impact on short-term returns. So should you be excited about companies that split their stock? I believe there is one reason to be optimistic about these events, but another serious reason to approach them with caution.

First, let’s define what a stock split is and why a company might want to do one.

As a company’s share price rises, it may eventually reach a level where average investors will find it difficult to afford even a single share. Amazon, for example, was recently trading above $2,000 before undergoing a 20-to-1 stock split, reducing its stock price to around $100. Shareholders received 19 additional shares for each share they owned, and the value of those shares was reduced proportionately, leaving the company’s market capitalization unchanged.

Falling stock prices put those stocks more easily within the reach of retail investors. One of the main purposes of stock splits is to increase liquidity, with the theory that a more reasonable price will entice more investors to buy the stock.

Let’s be 100% clear: a stock split shouldn’t be the reason you invest in a company. This financial maneuver does absolutely nothing to improve a company’s long-term performance.

That said, I like to see a company go through a stock split, because in most cases it follows a significant rise in the stock price, and therefore generally indicates that the company has probably been doing quite well. .

For example, since Amazon’s last spin-off in 1999, its stock price has risen more than 3,000%. When a stock goes up this big over 23 years, it’s usually because the underlying business has performed amazingly well.

Alphabet – Google’s parent company – split its shares in 2014 and has risen nearly 300% since then to more than $2,000 per share. This caused it to be split 20 to 1 this month.

Sometimes struggling companies try to take advantage of the investor excitement that stock splits generate to boost their stock price. For example, consider GameStopit is (NYSE: GME) recent 4-to-1 split.

The niche retailer’s stock price swings grabbed headlines in 2020 as retail investors staged a short squeeze that sent its stock price soaring. More attempts at short compression followed, but since peaking in January 2021, the meme stock is down over 60%.

It’s possible that GameStop management’s motivation for the recent split was to attract more retail traders in hopes of triggering another push. Or maybe the low stock price of around $30 will confuse investors into thinking it’s undervalued. But the important thing to remember is that absolutely nothing has changed in GameStop’s struggling business. Its finances are still in shambles and its valuation remains quite expensive at a price-to-book ratio of 7.5.

Investors should be on the lookout when struggling companies try to capitalize on the stock split mania to boost their stock prices. It’s usually a trap.

The easiest way to think about stock splits is to imagine a pizza. No matter how many slices you cut the pie into, the total amount of pizza remains the same size.

It’s the same with businesses. You can split the stock as much as you want, but the market capitalization does not change. Neither do the fundamentals of the underlying business.

While it’s nice to see the big winners in your portfolio share their shares, ultimately you’re better off focusing on the quality of the underlying business when making investment decisions.

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Suzanne Frey, an executive at Alphabet, is a board member of The Motley Fool. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a board member of The Motley Fool. Mark Blank holds positions at Shopify and Tesla. The Motley Fool owns and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Shopify and Tesla. The Motley Fool recommends the following options: $1140 January 2023 Long Calls on Shopify and $1160 January 2023 Short Calls on Shopify. The Motley Fool has a disclosure policy.