- A stock split is when a company decides to increase the number of shares by dividing its existing shares into additional shares.
- Stock splits don’t provide any economic value to the company. They just reduce the stock’s price, making it more affordable.
- Stock splits are often good signs for shareholders, attracting new investors and eventually leading to a share-price rise.
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As an investor, the idea of “splitting” anything is probably not at the top of your list.
But when it comes to stocks, your portfolio may benefit from a split.
A stock split occurs when a company makes its shares more affordable by dividing its existing shares into additional, less expensive shares.
In a stock split, the company’s overall value stays the same â€” a split may reduce the price per share but it doesn’t affect the company’s market capitalisation. There are simply more shares to go around.
If you’re already a shareholder in a company when it declares a stock split, not much changes. Nevertheless, it’s important to grasp how stock splits work, especially for understanding how the market may react post-split.
What is a stock split?
Public companies have a set amount of outstanding shares available in the market.
A stock split is exactly what it sounds like: It’s an action by a company’s board of directors to increase the number of shares of stock in the company by “splitting” its existing shares.
A stock can be split in as many ways as a company chooses, supplemented with ratios such as “2-for-1,” “3-for-1,” all the way up to “100-for-1”. All this tells you is how much one share is now worth. For instance, in a 2-for-1 split, every single share held by an investor now becomes two. The number of shares the investor has literally doubled.
When companies opt for a stock split, it increases the overall number of outstanding shares and lowers the value of each individual share. But that doesn’t mean the overall valuation of the company changes. Nor does the overall dollar amount of the investor’s stake.
Let’s use Apple’s most recent 4-for-1 stock split as an example. For simplicity’s sake, say you have one share in Apple’s stock. Via its 4-to-1 split, Apple grants you three additional shares (totaling four), but each share is then valued at a quarter of the original. The four shares are worth the same as the one share pre-split.
For existing shareholders, the result is the same â€” the total value of the shares remains consistent. There are just more pieces of the pie, so to speak.
For new investors, an announcement of a stock split can signal a time to buy, since a lower price per share means buying at lower prices. Overall, stock splits signal to the market that the company’s share price is growing and the company’s optimistic it will continue to do so in the future.
Why do companies split stock?
There are many reasons why a company may consider a stock split. Since stock splits don’t add economic value, much of it comes down to making the stock more attainable to everyday investors, and the behavioural benefits of that.
Here are three main reasons why a company may split a stock:
- Make the stock more accessible: The main purpose of a stock split is to reduce the price of an expensive stock â€” especially when compared to price levels of peers in the industry â€” making it accessible to more investors.
- Create more liquidity: Because a stock split increases the volume shares in circulation, it can result in greater liquidity, which makes it easier for the stock to be traded. Increased liquidity is better for investors as it makes buying and selling stocks at fair prices much simpler. As well, trades can be done much faster.
- Revive interest: When a stock splits, the company is often perceived to be a successful one. The fact that the share price of a company is so high that it must split its stock indicates to investors that the company has been successful and must be a good investment. A stock split also often increases the share price after its initial reduction. As the reduced price makes a stock cheaper, more investors are able to purchase it, driving up the demand and, therefore, the price.
What is a reverse stock split?
Generally speaking, a traditional stock split is considered a good thing. But there’s also what’s called a reverse stock split, and as you might guess, it’s the opposite.
A reverse stock split occurs when the quantity of outstanding shares is reduced and the stock’s price is increased. For example, if you had two shares in a company worth $US10 each, you would now have one share worth $US20.
Though regular stock splits, also known as forward splits, are a positive indication of the success of a company, a reverse stock split indicates a company in trouble. A business usually enacts a reverse stock split when the price of its stock has become so low that it is in danger of being thrown off a stock exchange â€” and not allowed to trade on it anymore.
In order to avoid being “delisted,” as this dire fate is known, the company will enact a reverse stock split, increasing the stock price and ensuring it stays on the market.
Investors should commonly avoid companies that have undergone a reverse stock split, unless the company provides solid plans to improve its performance.
The financial takeaway
In a stock split, a company increases the number of its shares by dividing its existing shares into more shares, thus reducing the price of each share. This results in shares that are more affordable and more attractive to investors.
When a company splits its stock, the current shareholders are not financially impacted. The value of their holdings remains the same; they just now have more shares â€” but at a lower price apiece. Their overall investment has the same value as before the split.
When a stock splits, its liquidity and trading volume often improves. Most companies that split their stock see an increase in the long-term growth of their share price. as more investors buy up the now-cheaper stock. This, in turn, often benefits existing shareholders as they see the value of their investment increase.
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