Written by Sahil Bloom.

Tesla ($TSLA) recently announced a stock split, which set off a frenzy of buying activity. If that left you scratching your head, you weren’t alone. So what is a stock split and how does it work? Here’s Stock Splits 101!

First, the basics. There are two types of stock splits: Conventional and Reverse. Let’s focus on Conventional, as it is the type that $TSLA announced. In a conventional split, a company issues more shares. Its share price is now lower, but the value of the Company does not change.

Tesla announced a 5-for-1 stock split. So what happens? You own 10 shares of Tesla at a pre-split price of $1500 per share. Post-split, you own 50 (10*5) shares at $300 ($1500/5) per share. You have more shares, but there are more outstanding. Your ownership did not change.

As always, I find it best to walk through these concepts by using a simple story. Imagine you are at a poker table in Las Vegas. You have $500 in the form of 5 $100 chips. Your only opponent has $1000 in the form of 10 $100 chips. The dealer asks to exchange some chips.

He exchanges each $100 chip for 10 $10 chips (10-for-1). So now you have 50 $10 chips and your opponent has 100 $10 chips. You still have $500 total and are in the same relative position as before the exchange. More chips, yes, but no better off. That was a stock split!

In a stock split, the company increases its shares outstanding (by some factor) and reduces the per share price (by that same factor). The total value of your existing ownership in the company stays the same, just like the total value of your chips at the poker table.

So to be clear, a stock split has absolutely no impact on the fundamental value of a stock. Then why might a company decide to execute a stock split? The most commonly stated reason: to allow smaller investors to buy the stock and improve the liquidity of the shares.

If you run a poker game and only allow $100 chips at your table, people with less than $100 cannot participate in your game. But in a digital age where buying fractional shares is possible, is this reasoning sound? Rationally speaking, perhaps not. Realistically, yes.

We humans are not perfectly rational creatures. Cognitive biases impact our decision making. Buying a given stock at $100 feels like a better bargain than buying it at $500, even if it buys you 1/5 as much ownership. Being able to afford more shares of a stock feels good.

To summarize, stock splits are quite simple and have NO DIRECT IMPACT on the fundamental value of a stock. They do, however, make the stock more affordable on a per share basis for average investors. This may improve the liquidity of the stock as new buyers enter the market. That was Stock Splits 101! I hope you found it helpful.