Whether you’re a seasoned investor or simply keeping up with market news, you’ve likely come across the term “stock split”. The purpose of a stock split is to increase the total number of a company’s outstanding shares – without issuing any new shares – by “splitting” each existing share. This also decreases the price per share.
How Do Stock Splits Work?
When companies launch an initial public offering (IPO), they sell a fixed amount of shares to the public. After this initial offering, the company can issue more shares, but these can lead to stock dilution and other complications.
Stock splits can be used to increase a company’s number of outstanding shares without diluting the ownership percentage of existing shareholders. This is achieved by splitting existing shares into multiple shares. The company’s market capitalization still remains the same, as the price of individual shares will decrease according to the ratio of the stock split.
A Simple Stock Split Example
To better explain what happens when a stock splits, we’ll use the example of a 2-for-1 stock split.
In this situation, the number of shares is doubled and the price of the shares is halved to compensate. If you owned 1,000 shares worth $2 each before the split, you would own 2,000 shares worth $1 each afterwards. The overall market value of your holdings would not change.
Why Would You Want a Stock to Split?
Stock splits can happen for a number of reasons but they’re generally done to attract more investors. Company shares become more affordable, effectively reducing the amount of initial capital required and allowing smaller investors to purchase shares.
Because they perceive greater upside potential and liquidity, investors (especially those with limited capital) would be more likely to buy 100 shares for $5 each instead of 10 shares for $50 each.
Due to the lower barrier to entry, stock splits are often followed by a surge in market activity, which can lead to improved stock performance over time. According to studies conducted by David Ikenberry, companies whose stocks split outperformed the market by 8% after one year – and over 12% after three years.
Are Stock Splits Good?
Stock splits generally occur when a company’s share price is high. This can be an indication that the company is in good health. Stock splits don’t add any actual value to a stock, but they do increase liquidity and affordability, which are both good for investors.
Are There Disadvantages of Stock Splits?
Market activity generally increases after a stock split. While that can sometimes lead to increases in share price, it can also lead to greater volatility.
How Does a Stock Split Affect Stock Prices?
When a company’s stock splits, its market capitalization remains the same, meaning the actual value of its shares is unchanged. However, the price of the shares decreases proportionally to the ratio of the stock split, resulting in a lower share price.
4 Benefits of Stock Splits for Companies
There are advantages of stock splits that benefit companies, including:
1. Attracting Investors
As mentioned above, a stock split often attracts investors due to the reduction in stock price and lowered barrier to investing.
2. Increasing Number of Shares
Rather than issuing new shares through a secondary offering, companies can increase their number of shares by performing a stock split. This approach helps them avoid stock dilution.
3. Facilitating Market Activity
Following a stock split, there is often an increase in trading since the shares are more affordable. This can also lead to overall increases in share price.
4. Improving Liquidity
Stock splits increase the volume of shares available. This reduces the bid-ask spread and makes it easier for investors to buy and sell shares.
How Does a Stock Split Benefit Shareholders?
When it comes to stock splits for investors, there are plenty of advantages, such as:
1. Greater Affordability
Stock splits cause the price of the company’s shares to decrease, making them more affordable for new investors.
2. Increased Liquidity
The increase in the number of outstanding shares means more trading volume. This makes it easier for investors to buy and sell shares.
3. Easier Diversification
Since there are more shares and share prices are lower, it’s easier to diversify and rebalance portfolios.
4. Potential Increase in Share Price
Stock splits are often followed by increased market activity that could lead to higher share prices (over the short and long term).
5. Greater Upside Potential
A stock with a lower price has more room to grow than a stock with a higher price. Plus, price increases have a greater impact since they account for a greater portion of the share’s value.
How Stock Splits Are Written
Stock splits are written as a ratio of the new shares to old shares. If a company announces a 2:1 (or 2-for-1) stock split to double their amount of shares, shareholders would receive two shares for every one share they hold.
Stock Split Examples
Stock splits are extremely common so there are plenty of examples of stock splits in the media. Some of the most significant examples of stock splits include:
What Are Reverse Stock Splits?
Reverse stock splits (also called stock merges) are just like regular stock splits but they work in the opposite direction. While a regular stock split increases the number of shares – and decreases the share price according to a given ratio – reverse stock splits decrease the number of shares and increase the share price, according to a given ratio.
Example of a Reverse Stock Split
Let’s say a company has 100,000 outstanding shares at a price of $10 each, and it performs a 1-for-10 reverse stock split. After the reverse split, it would have 10,000 outstanding shares at a price of $100 each. Just like a regular stock split, reverse stock splits don’t change the underlying value of the shares: They simply change the number and price of the shares.
4 Reverse Stock Split Disadvantages
Unlike regular stock splits (that generally occur when a company is in good health), reverse stock splits often happen when a company is in distress. There are a number of reasons why a reverse split can be bad for investors:
1. Inflated Prices
Reverse stock splits are used to boost share prices without providing any additional value. They can be seen as an attempt to artificially inflate prices.
2. Lower Liquidity
Since the number of outstanding shares decreases, there is a reduction in liquidity which can make it more difficult for investors to buy and sell the shares.
3. Avoid Delisting
Reverse stock splits are also used to avoid being delisted from a stock exchange, as some exchanges require shares to be above a certain price to remain listed. This can be considered a bad sign because it indicates that share prices aren’t high enough to remain on the exchange without company intervention.
4. Reduced Number of Shareholders
By consolidating shares, reverse stock splits can reduce the number of shareholders. If a shareholder doesn’t hold enough of the old shares to receive a new share, they would instead receive a cash payout (and would no longer have an ownership interest in the company).
Reverse Stock Splits vs Stock Splits: Benefits of Each
Reverse stock splits and regular stock splits are used by many companies, but they each offer different benefits:
Reverse Stock Split:
Reduce number of shareholders
Increase share price
Attract larger investors
Appear more legitimate
Regular Stock Split:
Make shares more affordable
Greater number of shares
Boost trading volume
Increase upside potential
Stock Split vs. Stock Dividend
Stock splits and stock dividends both increase the number of outstanding shares, but they do so in very different ways.
A stock split divides existing shares into more shares. The company doing the stock split is effectively increasing the number of outstanding shares by a predetermined ratio (while decreasing the share price proportionally).
A stock dividend, however, is a fixed amount of shares paid to existing shareholders in lieu of cash dividends. It also increases the number of outstanding shares and reduces the share price proportionally.