Stock split definition
A stock split occurs when a company decides to increase the number of shares outstanding to boost the stock’s liquidity. Though the number of shares increases, the overall value of shares outstanding stays the same because the split does not fundamentally change the company’s value. 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. Read also:Stock Trading for BeginnersDividend Investing for Beginners10 Best Stock Trading Books15 Top-Rated Investment BooksWhat is Investing?
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 stock 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, stock splits by blue-chip companies (established, stable, and well-organized corporations) are a bullish signal for investors. Note: There is no particular advantage for those that already own stock at a company that has split its stock; the value of their shares will not change. Nevertheless, a stock split can motivate those interested in becoming shareholders to buy. And while the ability for more investors to buy in can bump up the stock price, this usually is only a temporary change driven by the increase in demand.
Example of a stock split
In August 2020, Apple (AAPL) split its shares 4-for-1. Right before the split, each share was trading at around $540. Post-split, the share price was $135 (approximately $540 divided by 4). As a result, Apple’s outstanding shares grew from 3.4 billion to about 13.6 billion, while the market capitalization remained practically unchanged at $2 trillion. A shareholder would hold four shares of AAPL for each previously held share. Most recently, Google parent company Alphabet (GOOG) announced on February 1, 2022, that it is doing a 20-for-1 stock split. That means that on July 15, shareholders will receive 19 additional shares for every one they own at the close of business on July 1. Alphabet stock rose more than 9% in after-market trading following the news.
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 stock 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 stock 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 stock 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.
