There are various ways in which companies can manipulate their share price. One of these ways is implementing a corporate action called a stock split. The following guide, illustrated by examples, will look at how this process works, how it is applied, and how it can affect an investor’s portfolio.
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Stock split definition
When a company goes through a split, it will use a particular split ratio to indicate how many new shares each outstanding share will be divided into. The most standard forward (or conventional) split ratios are 2-for-1 (2:1) or 3-for-1 (3:1), which means investors will receive two or three shares, respectively, for each share they held beforehand.
A company might also decrease the number of outstanding shares, increasing the share price. As the name suggests, this technique is called a reverse stock split. So, in a 2:1 reverse stock split, a company would merge two shares into one, which means investors will receive one share for the two they held before.
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What is Investing?
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How does stock split work?
A stock split is a way for companies to change the per-share price without changing market capitalization. Market capitalization (cap) refers to the total value of a company’s issued stock. It is calculated by multiplying the price per stock by the total number of shares outstanding.
For instance, let’s imagine Company A has 10 million shares outstanding, and the stock is trading at $50 per share. Its market cap will be $500 million (10 million multiplied by 50). Now, the company’s board of directors has decided to split the stock 2-for-1. Immediately after the split is implemented, the number of shares outstanding would double to 20 million. By contrast, the share price would be halved to $25, leaving the market cap unchanged at $500 million (20 million times 25).
Therefore, while the number of outstanding shares changes, the company’s overall valuation and the value of each shareholder’s stake remain the same. So if an investor has one share of a company’s stock valued at $10, after a 2-for-1 stock split, they would have two shares of stock at $5 each. The two shares combined are worth the same as the one you started with, and the value of your investment remains unaffected.
Why would a company split its stock?
Many public companies implement a stock split after the share price has exhibited significant growth. Reducing the trading price into a more comfortable range will make their stock look more attractive from a per-share price and encourage investors to buy it.
Basically, most investors might be more willing to buy, say, 100 shares of a $10 stock instead of 1 share of a $1,000 stock. This is because 100 shares are considered a board lot, a standardized number of securities defined as a trading unit by a stock exchange.
Furthermore, companies will often split their stock to create more liquidity. The higher the number of shares outstanding, the greater the liquidity, facilitating trading and narrowing the bid-and-ask spread. Increasing the liquidity makes it easier for investors to buy and sell the stock without too substantial an effect on the share price.
Moreover, it can help companies buy back their own stock at a lower price since their orders would not push up the share price of a more liquid stock as much.
A company can decide to split the stock by any ratio. For example, a stock split may be 2-for-1, 3-for-1, 10-for-1, 100-for-1, etc. A 3-for-1 split means there will now be three shares for every one share held by an investor; namely, the number of outstanding shares in the market will triple. However, the cost per share after the 3:1 split will be divided by three, keeping the value of the stock the same.
What does it mean for investors?
A stock split is normally an indication that a company is thriving and its stock price has increased. Though theoretically, it should not affect a stock’s price, it often results in renewed investor interest, which can positively influence the stock price. While this effect may wither over time, splits by blue-chip companies (established, stable, and well-organized corporations) are a bullish signal for investors.
Stock split example
Apple stock split
Google stock split
Reverse stock split explained
A reverse stock split is the opposite of a stock split (also known as a forward stock split). A reverse stock split occurs when a company consolidates the number of existing shares of stock into fewer higher-priced shares. Like with a forward split, the market value of a company after a reverse split stays the same.
A company would primarily pursue this corporate action to bump its per-share price. Firstly, to avoid being delisted from a stock exchange for not meeting the minimum bid price required for a listing. Secondly, to attract big investors, as many institutional investors and mutual funds have policies against investing in stocks priced below a preset minimum per share.
Another reason a company might opt for a reverse split is to make its stock look more appealing to investors who may regard higher-priced shares as more valuable.
The downturns of reverse stock split
A reverse stock split can often signify a company in distress and is not perceived positively by market participants. It is usually an indicator that the stock price has plummeted, and the company’s board of directors is attempting to inflate the prices artificially without any fundamental business proposition. Furthermore, as the number of shares is reduced on the market, the stock’s liquidity is generally also affected, making the stock more volatile for traders.
In conclusion
Ultimately, a stock split or a reverse split does not affect the company’s intrinsic value, so it won’t have a substantial practical impact on its current investors. Nonetheless, a stock split can indicate to investors that a company is thriving, in contrast to a reverse split which often suggests a company is experiencing some turbulence.
A stock split’s most significant impact is on new investors, eyeing up a particular stock and hoping to purchase a round lot of shares at a lower cost. Thus, a stock split can provide a powerful motivator to get in the action.
Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
FAQs about stock splits
What happens to my shares if they undergo a stock split?
After a split, the stock price will decline since the number of outstanding shares has increased. This, however, does not change the market capitalization of a company, and the value of your held shares will remain the same.
What are the types of stock splits?
The most standard stock splits are traditional stock splits, such as 2-for-1 and 3-for-1. For example, in a 2-for-1 stock split, a shareholder receives two shares after the split for every share they owned before the split. In a 3-for-1 split, they receive three shares for every share. However, split ratios can go various ways, including 20-for-1, 100-for-1, etc.
Why do companies split stock?
A frequent reason for a stock split is toto make shares more affordable for investors. This can increase liquidity, broaden the shareholder base, and make the stock more attractive to small investors. It doesn’t change the company’s overall value, but it can promote more active trading and accessibility of the stock.
Are stock splits good?
A stock split makes the stock more accessible and appealing, particularly to small investors, and is often seen as a positive sign reflecting the company’s growth or potential for future growth. Additionally, the post-split lower nominal share price can attract new investors, possibly leading to an uptick in the stock’s value due to increased demand. Indeed, a 2-for-1 stock split increases the marketability of the stock because it usually occurs after the company’s stock price has risen significantly, potentially deterring new investors with higher per-share costs.
What are the disadvantages of stock split?
Stock splits can lead to increased administrative costs, create potential investor confusion, possibly result in perceived lower company value due to reduced share price, and might increase stock volatility without adding real value to the company.
What is a reverse stock split?
A reverse split reduces a company’s outstanding shares increasing per-share value. It is typically done to avoid being delisted from an exchange if the stock is nearing the minimum share price allowed on that exchange. As a result, it might be wise to steer clear of investing in a stock that has recently undergone a reverse split.
What is the difference between a stock split vs stock dividend?
A stock split increases the number of shares by splitting each existing share into multiple shares, reducing the share price but not changing the total value of holdings. A stock dividend is a payment made in additional shares based on the number of shares already owned, reflecting a distribution of earnings. Both increase the number of shares but have different implications and reasons.
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