Understanding stock splits

Although the company issues more shares, the overall value of the investment does not change immediately after the split. In simple terms, a stock split increases the number of shares you own while lowering the price per share proportionally, keeping the total value the same.

The Basics of Stock Splits

Let’s break down how stock splits work:

If a company announces a 2-for-1 stock split, each existing shareholder receives one additional share for every share they already own. For example, if you owned 100 shares priced at $50 per share before the split, after a 2-for-1 stock split, you would own 200 shares priced at $25 per share.

In this case:

Before the split: You have 100 shares at $50 each, so the total value of your investment is $5,000.

After the split: You now have 200 shares at $25 each, so the total value remains $5,000.

The key takeaway is that a stock split doesn’t impact the overall value of your investment in the company—it simply changes the number of shares and their price per share.

Types of Stock Splits

Forward Stock Split: This is the most common type. In a forward split, a company issues additional shares to its existing shareholders. The most common splits are 2-for-1, 3-for-1, or even 10-for-1. In these cases, shareholders receive more shares, but each share is worth less.

Reverse Stock Split: In contrast to a forward split, a reverse stock split reduces the number of outstanding shares while increasing the value of each share. For example, in a 1-for-2 reverse stock split, a shareholder would exchange two existing shares for one new share. A reverse stock split is typically used by companies whose stock prices have fallen to very low levels, as a higher stock price can make the company appear more valuable to potential investors and may help meet listing requirements for stock exchanges.

Why Do Companies Split Their Stock?

Making Shares More Affordable: A company might conduct a stock split to reduce the price of its stock to a more attractive level for investors. For example, if a company’s stock price rises significantly over time (for instance, to $1,000 per share), it might become unaffordable for individual investors. By splitting the stock, the company can lower the price and make it easier for a wider range of investors to purchase shares.

Increasing Liquidity: Stock splits can improve the liquidity of a company’s shares. By increasing the number of shares outstanding and reducing the price per share, it might be easier for investors to buy and sell shares without affecting the stock price as much.

Signaling Confidence: Companies often use stock splits as a signal of their confidence in future growth. A company may split its stock when its stock price has been rising steadily, which can be interpreted as a sign of a company’s success. A stock split can make the stock appear more attractive to investors, potentially leading to more demand.

Attracting Small Investors: Many individual investors might feel more comfortable buying shares in smaller denominations. A stock split makes shares more accessible to small retail investors who might not want to pay hundreds or thousands of dollars per share.

The Effect on Stock Price

After a stock split, the price per share will decrease in proportion to the split ratio. However, it is important to note that the decrease in price does not reflect a decrease in value. The total market capitalization (the total value of all outstanding shares) of the company remains the same immediately after the split, assuming no other factors come into play.

For example:

Before the split: 1,000 shares at $100 per share = $100,000 market value.

After the split (2-for-1): 2,000 shares at $50 per share = $100,000 market value.

How Do Stock Splits Affect Shareholders?

The immediate effect on shareholders is that they will own more shares, but each share will be worth less. However, as mentioned earlier, the total value of their holdings doesn’t change immediately after the split. Investors who owned 100 shares before the split will now own 200 shares, but the price per share will be halved. If the company’s value remains the same and the stock behaves as expected, shareholders could see an increase in their holdings over time.

The Psychological Impact

In some cases, stock splits can have a psychological effect on investors. A lower share price might make the stock appear more affordable and attractive to small investors, even though the total market capitalization remains unchanged. This can potentially drive up demand and result in a short-term increase in the stock price. Moreover, stock splits may indicate to the market that the company is performing well, which could contribute to investor confidence.

Stock Splits vs. Stock Dividends

A stock split should not be confused with a stock dividend. A stock dividend is a distribution of additional shares to existing shareholders, but unlike a stock split, a stock dividend typically does not change the share price. Instead, the company pays out a dividend in the form of extra shares, usually as a percentage of the shares already owned.

Conclusion

A stock split is a common corporate action that can make shares more accessible to a wider range of investors by lowering the price per share. While a stock split does not change the value of an investor’s holdings immediately, it can affect the liquidity and perceived attractiveness of a stock. Stock splits are often viewed as a positive sign, signaling company growth and confidence, but investors should be mindful of the underlying fundamentals of the company to assess whether the stock split will lead to long-term value.