Aug 28, 2023
What Is a Stock Split?
|What is a stock split?|
A stock split is when a company divides its stock to create additional shares in an attempt to decrease the dollar price per share. While a stock split lowers the individual share price, it does not weaken the overall value for current shareholders. In other words, you may own more shares after a stock split, but the value of all the stock you own in the company remains the same. Because stock splits are fairly common, it can be helpful for investors to understand how they work, why they happen, and what they mean if you’re a shareholder in a company.
In this article, we’ll cover:
- How stock splits work
- Different types of stock splits
- Reasons behind stock splits
- What stock splits mean for shareholders
How stock splits work
Stock prices are usually determined by supply and demand among buyers and sellers. Stock splits decrease the cost of individual shares while simultaneously increasing the number of shares available. This creates an inverse relationship between the decreased stock price and the increased number of outstanding shares. Existing shares are divided into multiple smaller units, resulting in a higher overall count of shares available in the market. Shareholders wind up with a larger number of shares with a lower value per share, but the value of their investment doesn’t change.
A stock split does not affect a company’s market cap. Market cap is determined by multiplying the price per share by the number of shares outstanding. When a company goes through a stock split, the number of shares increases and the price per share decreases by a proportional amount, leaving the market cap the same.
Example of a stock split in action
Say you own four shares of stock in a leading healthcare company called ABC Med. The current stock price is $400 per share, making the total value of your investment $1,600 (4 x $400 = $1,600).
ABC Med announces a 2-for-1 stock split, meaning the number of available shares will double, while the price of each share will be halved. ABC Med will give you two shares for every share you already own.
After the split, you will own eight shares with a price per share of $200. Your total investment value will remain $1,600 (8 x $200 = $1,600), and ABC Med’s market cap will remain unchanged.
Different types of stock splits
Stock splits come in multiple forms, but some of the most common include 2-for-1, 3-for-1, and reverse stock splits. Google’s parent company Alphabet even initiated a 20-for-1 split in 2022, offering investors twenty new shares for every existing single share. Regardless of the ratio, each of these different types of stock splits will change the number of shares you own while retaining the overall value of your investment.
2-for-1 Stock Split
In a 2-for-1 stock split, you will receive two new shares for every one share you currently own. While the number of shares you own will double, the price for each share will be cut in half. A company may opt for a 2-for-1 split to increase liquidity, broaden investor participation, or create the perception of a more affordable stock to attract new investors.
3-for-1 stock split
A 3-for-1 stock split is structured similarly to a 2-for-1 split. For every existing single share you own, the company will give you three new shares. The individual stock price will decrease to ⅓ of its previous value, but you will receive three times the number of shares. 3-for-1 stock splits increase liquidity even more than 2-for-1 splits and make shares even more affordable, which can be attractive to smaller investors.
Reverse stock split
A reverse stock split is just the opposite of a regular stock split. Instead of receiving more shares at a reduced price, investors receive fewer shares at a proportionally increased price. Reverse splits are often used to avoid delisting from exchanges when a company’s stock price falls too low. Reverse stock splits aim to boost the stock price and prevent negative perceptions often associated with very low stock prices.
Reasons behind stock splits
Stock splits generally occur to enhance liquidity, make shares more affordable, attract more investors, or signal the company’s confidence in its future prospects.
Liquidity refers to how quickly an investment can be sold without having an impact on its value. Having an increased number of shares available after a stock split makes it easier for investors to buy and sell them without impacting the value. Thus, stock splits can lead to improved market liquidity. Enhanced liquidity can also narrow the bid-ask spread between buyers and sellers, making investing more cost-effective.
Making shares more affordable
High stock prices can act as a barrier to potential investors, particularly those who are new to investing or have limited funds. Stock splits make shares more affordable, thereby allowing a broader range of investors to participate.
Attracting more investors
Lower-priced shares have the potential to attract casual investors who are more likely to invest smaller amounts of money. The lower cost following a stock split allows smaller investors to purchase shares in multiple companies, which can support better portfolio diversification.
Positive signal to the market
Companies may announce a stock split as a way to send a positive signal to the market. Stock splits might imply that a company is in a growth phase and expecting stock prices to increase soon. If the company is projecting confidence in its future prospects, chances are that investors will take notice, which can boost confidence in the company’s prospects and potentially increase trading of its stocks.
Famous stock split cases
Apple, one of the most highly valued companies in the world, has split five times since the company went public in December of 1980. Its most recent split occurred in August 2020 on a 4-for-1 basis. Other splits include 7-for-1 in June 2014, and 2-for-1 splits in February 2005, June 2000, and June 1987. Another highly valued company, Amazon, has split four times since 1998, with its most recent 20-for-1 split occurring in June 2022. Often, these splits were intended to make the stock more accessible and attractive to new investors.
What stock splits mean for shareholders
The most important thing to remember is that while the number of shares you own and the price of those individual shares will change as a result of a stock split, it will have no impact on the market value of the company or the value of your investment. The share price is adjusted proportionally to the split ratio, and shareholders receive additional shares based on that split ratio.
The impact of a stock split can differ for short-term traders vs. long-term investors. Long-term investors typically focus on the company’s fundamentals and performance history rather than the split itself. But if a stock split generates more interest among retail investors, there’s a chance it could increase demand, driving up share prices over time; that may be a benefit for shareholders who hang onto their stocks over the long term. Short-term investors who intend to sell shares sooner rather than later aren’t likely to see a benefit from a stock split, since the value of assets remains the same. That said, it’s possible for a stock split to trigger volatility and trading volume, which could increase or decrease the stock price in the short term.
What is a stock split’s impact on your investing strategy?
Stock splits are neither inherently good nor inherently bad for investors, but they do happen. If you’re looking for a lower-cost entry into the stock market, purchasing shares after a split could allow you to buy stocks that may have been out of your budget before. And if you’ve purchased stock just before a split, be aware that you may see some volatility in the short term and avoid panicking.
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