What is a stock split?
A stock split occurs when a company increases the number of shares to increase its stock priceliquidity. Even if the number of shares outstanding increases by a certain multiple, the total dollar value of all outstanding shares remains the same because a split does not fundamentally change the value of the company.
The most common split ratios are 2-to-1 or 3-to-1 (also called 2:1 or 3:1). This means that for every share held before the split, each shareholder will hold two or three shares respectively after the split.
Key learning points
- A stock split is when a company increases the number of shares outstanding to increase the liquidity of the stock.
- Although the number of shares outstanding increases, the overall market value of the company will not change as the price of each share will also be divided.
- The most common split ratios are 2-to-1 or 3-to-1, meaning each share before the split becomes more shares after the split.
- A company chooses to conduct a stock split to intentionally lower the price of a single share, making the company's shares more affordable without losing value.
- A reverse stock split is the opposite transaction in which a company decreases rather than increases the number of shares outstanding and increases its stock price accordingly.
This is how a stock split works
A stock split is a corporate action in which a company issues additional shares to shareholders, increasing the total by the specified ratio based on the shares they previously owned. Companies often choose to split their shares to lower the trading price to a more comfortable range for most investors and to increase the liquidity of trading their shares.
Most investors feel more comfortable buying, say, 100 shares of a $10 stock, rather than 1 share of a $1,000 stock. So when the stock price has risen significantly, many publicly traded companies eventually declare a stock split to reduce it. Although the number of shares outstanding increases in a stock split, the total dollar value of the shares remains the same compared to the amounts before the split because the split does not make the company more valuable.
A company's board of directors can choose to split the shares in any desired ratio. For example, a stock split can be 2-for-1, 3-for-1, 5-for-1, 10-for-1, 100-for-1, etc. A 3-for-1 stock split means that for each share that one investor owns, there will now be three. In other words: the numberoutstanding shareson the market will triple.
In contrast, the price per share after a 3-for-1 stock split can be reduced by dividing the old stock price by 3. This is because a stock split increases the value of the company, measured usingmarket value.
Special considerations
The market value is calculated by multiplying the total number of outstanding shares by the price per share. For example, suppose that XYZ Corp. has 20 million shares outstanding and its shares are trading at $100. Its market cap will be 20 million shares x $100 = $2 billion.
Let's say the company's board of directors decides to split the stock 2 for 1. Immediately after the split becomes effective, the number of shares outstanding will double to 40 million, while the stock price will be halved to $50. Although both the number of shares outstanding and the market price have changed, the company's market cap remains unchanged at (40 million shares x $50) $2 billion.
In Britain, a share split is called a scrip issue, bonus issue, capitalization issue or free issue.
Benefits of a stock split
Why do companies have to go through the hassle and expense of a stock split? First, a company often decides to split when its stock price is quite high, making it expensive for investors to purchase a standardtavle partyof 100 shares.
Second, the higher number of shares outstanding can result in larger sharesliquidityfor the shares, which facilitates and can reduce tradingbid-ask spread. Increasing the liquidity of a stock makes trading the stock easier for buyers and sellers. This can help companies buy back their shares at a lower price because their orders will have less impact on a more liquid security.
Although in theory a split should have no effect on the share price, it often results in renewed interest from investors, which can have a positive effect on the share price. While this effect may diminish over time, the stock splitsblue chipcompanies is a bullish signal for investors. A stock split may be seen by some as a company wanting a greater future growth trajectory; for this reason, a stock split typically signals management's confidence in a company's prospects.
Many of the top companies routinely see their stock price return to pre-split levels, leading to another stock split. For example, Walmart split its stock eleven times on a 2-for-1 basis between the retailer's stock market debut in October 1970 and March 1999. An investor who bought 100 shares of Walmart.IPO(IPO) would have seen the stake grow to 204,800 shares over the next 30 years without further purchases.
Disadvantages of a stock split
Not all facets of a stock split benefit a company. The process of a stock split is expensive, requires legal oversight and must be carried out in accordance with regulationsregulatory laws. The company that wants to split its shares has to pay quite a lot to keep the price from moving above market value.
A stock split is not worthless, but it does not affect the fundamental position of a company and therefore does not create additional value. Some compare a stock split to cutting a piece of cake. If the dessert tastes terrible, it doesn't matter whether it's cut into 10 or 20 pieces.
Some opponents of stock splits see the move as having the potential to attract the wrong group of investors. Consider Berkshire HathawayA sharetrade for hundreds of thousands of dollars. If Warren Buffet had split the stock, many traders in the general public could afford to buy his company's stock. Instead, in order to maintain share ownership as exclusive, a company will deliberately not split its shares.
Finally, there are implications for deliberately lowering the company's stock price. Public exchanges such as NASDAQ require shares to trade at or above $1. Should the stock price fall below $1 for thirty consecutive days, the company will receive a compliance alert and have 180 days to return to compliance. Should the company's share price still not meet minimum pricing requirements, the company is at risk of becomingdeleted.
Example of a stock split
I August 2020, Apple (AAPL) splits its shares 4 to 1.Just before the split, each share was trading at around $540. After the split, the open market price per share will be $135 (approximately $540 ÷ 4).
An investor who owned 1,000 shares of the stock before the split would have owned 4,000 shares after the split. Apple's number of shares outstanding rose from 3.4 billion to about 13.6 billion, while its market capitalization remained largely unchanged at $2 trillion.
A company can choose to split its shares as many times as it wants. For example, Apple also split its stock 7-for-1 in 2014, 2-for-1 in 2005, 2-for-1 in 2000, and 2-for-1 in 1987.
To convert some pre-split shares into post-split shares across multiple splits, multiply the ratio of each split. For example, a single share before the 1987 split would have ultimately been split into 224 shares after the 2020 split. This is determined by multiplying 4, 7, 2, 2 and 2.
Stock Splits vs. Reverse stock splits
A traditional stock split is also called a forward stock split. Areverse stock splitis the opposite of a forward stock split. A company that conducts a reverse stock split reduces the number of shares outstanding and increases the stock price proportionately. As with a forward stock split, the market value of the company remains the same after a reverse stock split.
A company taking this corporate action may do so if its share price has fallen to a level where this is likely to happendeletedfrom an exchange because it does not meet the minimum price for an IPO. Certain investment funds are not allowed to invest in shares below a predetermined minimum per stock. A company can do that toochoose a reverse splitto make its stock more attractive to investors who view higher share prices as more valuable.
INreverse/forward stock splitis a special stock split strategy used by companies to eliminate shareholders with less than a certain number of shares. A reverse/forward stock split consists of a reverse stock split followed by a forward stock split. Reverse splits reduce the total number of shares a shareholder owns, paying out some shareholders who have less than the minimum required by the split. Forward stock splits then increase the number of shares owned by the remaining shareholders.
What happens if I own shares that undergo a stock split?
When a stock splits, registered shareholders are credited with additional shares that are similarly reduced in price. For example, in a typical 2:1 stock split, if you owned 100 shares that were trading at $50 just before the split, you would own 200 shares at $25 each. Your broker will handle this automatically, so you don't have to do anything.
Does a stock split affect my taxes?
No. The receipt of the additional shares will not result in taxable income under applicable U.S. law. Thattax baseeach share owned after the stock split will be half of what it was before the split.
Are stock splits good or bad?
Stock splits are generally done when a company's stock price has risen so high that it can become a barrier to new investors. Therefore, a split is often the result of growth or the prospects for future growth and is a positive signal. Also, the price of a share that has just been split may rise if the lower nominal share price attracts new investors.
Does the stock split make the company more or less valuable?
Stock splitsneither addition nor subtractionfundamental value. The split increases the number of outstanding shares, but the total value of the company does not change. Immediately after the split, the share price is adjusted downwards proportionally to reflect the market value of the company. When a company pays dividends,dividend per stockwill be adjusted accordingly to keep total dividend payments the same. Demergers also do not lead to dilution, which means that shareholders retain the same voting rights as before.
Can a stock split be anything other than 2-for-1?
While a 2:1 stock split is the most common, any other ratio can be used as long as it is approved by the company's board of directors and, in some cases, its shareholders. Split conditions can be e.g. are 3:1, 10:1, 3:2, etc. In the latter case, if you owned 100 shares, you would receive 50 additional shares after the split.
