A stock split happens when a company divides its existing shares into an increased number of shares without issuing new shares or diluting its shareholders.

Let’s look at why companies do stock splits, and if that is a good indicator for investors.

What is a stock split?

A stock split is a process where companies split or divide their existing shares into more shares. It means the process increases the number of outstanding shares for a company.

The board of directors chooses to issue more shares of the company, without diluting shareholders. This increase in the number of outstanding shares lowers the price at which the stock is trading. The lower price usually attracts more retail investors. 

Stock splits can increase the number of outstanding shares by a certain factor. They will usually be referred to as an X-for-1. The X is the factor by which the company’s board of directors wants to multiply the shares by. 

It may choose a suitable ratio for the split depending on its objectives. Commonly, companies choose a 2-1 or 3-1 split ratio which means 2 shares for every 1 and 3 shares for every 1 share existing respectively.

As a shareholder and investor, you will still control the same percentage of the company as you did before. Thus, a stock split only increases the number of shares outstanding. It does not increase the market capitalization or valuation of the company.

Example:

Let’s say you own 10 shares of company XYZ, and they decide to do a 2-for-1 stock split. After the stock split, you will have 20 shares, that represent the same ownership stake as before.

How does a stock split work?

A public company may decide to increase the number of shares outstanding through a split. The board of directors can decide any useful ratio for the split.

For instance, if a company had 1 million shares trading and it decides a 3-1 split, it will have 3 million shares outstanding after the split is completed.

Every shareholder will get the same proportion of additional shares as declared by the company.

Theoretically, the market capitalization of the company does not change. Suppose, a company had 1 million shares at $30 at the split date for a 3-1. After the split, its share price will decrease to $10 (theoretically) and the total market cap will be the same $ 30 million as before.

Why do companies do stock splits?

There are 2 main reasons why companies do stock splits:

  • Attract retail investors, and control the share price
  • Increase liquidity

Attract retail investors, and control the stock price

A company may want to decrease its share price intentionally. It happens when a company goes through hyper-growth stages. A higher share price would soon become out of reach for retail investors.

Companies always try to make sure that their share price does not get either too high or too low, and one of the ways of doing it is through a stock split. 

This happens for two reasons. On one hand, you want to make sure the price is not too high so that you can attract retail investors to invest in your company’s stock. On the other hand, a low share price could give a bad impression about a company.

It makes it look like a penny stock, and it prevents the stock from being listed in certain stock exchanges. For those reasons, companies adjust the number of outstanding shares, without diluting existing shareholders.

Increased liquidity

A stock split will result in lower share prices and increased trading volumes. It means a split will increase the liquidity for the stock. This is one of the greatest advantages, as low trading volumes in some stocks could create a lot of price volatility.

In turn, high price volatility could prevent some investors from investing in the stock. They might perceive it as a risky investment, and therefore they want to avoid those stocks.

There are clear advantages to splitting stocks

Having a certain stock price is important to attract the attention of some retail investors. If your stock is trading at over $1,000, investors might find it hard to commit such a large sum of money to just one stock. 

So companies prefer that their stock trades around two to three digits.

Increasing the outstanding number of shares also increases the market liquidity for that particular stock. Since the outstanding number of shares increases, the daily traded volume will increase.

Is a Stock Split Good?

A stock split is considered good for the company and its investors. When we dig deeper, we see there is not much of the difference for both the company and its investors.

The company will keep the same market capitalization. However, it will increase liquidity due to increased share trading.

In the long run, the share prices will again rise if the company continues to perform well. Therefore, the company may need another stock split.

From an investor’s perspective, the split does not affect their net wealth. Their total investment remains the same as only the number of shares they own increases.

A split resulting in lower share prices will be more accessible for retail investors which could be a great benefit for many.

Do stocks go up after stock splits?

Stock prices will go down on the split date. The total share price will be divided in the same proportion as the split ratio.

For instance, if a share was trading at $30 and it goes through a 3-1 split, its new share price will go down to $10.

As a split is usually considered a bullish signal, the share price will increase again due to the increased demand for the shares.

Is it better to buy stocks before or after a stock split?

Since stocks tend to go up after announcing a stock split it is better to buy a stock before it splits. 

In practice, not much would change for investors with a stock split, only in terms of liquidity. You could buy more shares with the same initial investment than you could earlier but your total ownership of the company remains the same.

Investors should consider that a share price usually goes up immediately after a stock split. However, it only happens when the market perceives the split as a bullish signal.

Do you lose money when a stock splits?

Existing shareholders neither gain nor lose money when a stock splits. Their net worth remains the same after a stock split.

All other things being constant, a split has no possible way to affect the net worth of shareholders.

Shareholders could only lose money if the stock does not perform well after the split. Similarly, shareholders can gain through a split, if the stock continues to perform well.

Issuing shares vs. stock split

The key difference between the two concepts is dilution. When a company issues new shares, it is diluting existing shareholders. This means that you will control the number of shares, but because the share count increased your ownership of the company is reduced. 

A stock split simply increases the number of shares for all the shareholders. Issuing shares can be detrimental for investors, as the percentage of the company they control is reduced. Stock splits, on the other hand, are just a way to make the stock more attractive.

Reverse stock split definition

Companies can also reduce the number of shares through a reverse stock split. This way you will see your total number of shares being reduced. 

Your shares still represent the same ownership in the company as before. The reverse stock split simply divides the number of shares you already own by a factor.

Example:

Let’s say you have 100 shares of company XYZ, and they decide to do a 1-for-10 reverse stock split. After it is completed you will have 10 shares of the company, representing the same value.

Reverse stock split vs. buyback

There might be some confusion when it comes to these concepts, but they are very distinct from each other. A buyback requires the company to purchase its shares back from shareholders. 

In order to conduct it, it usually goes on the open market and acquires a certain number of shares. This reduces the total number of outstanding shares and increases your ownership of the company. 

A reverse stock split, simply reduces the number of outstanding shares, dividing it by a certain number. You retain the same ownership in the company, you just have fewer shares in number. 

What are the reasons behind reverse stock splits?

The same way a high share price can deter investors from buying a particular stock, the same happens with lower-priced stocks. 

Lower-priced stocks usually tend to have negative connotations and are often described as penny stocks. This puts an unnecessary bad view on the company, and investors might avoid investing in that stock altogether. 

Another reason that explains a reverse stock split, is the fact that some stock exchanges will require stocks to be traded at a certain price. 

To remain in a particular stock exchange, companies might have to do a reverse stock split. So that their share price remains around a certain level.

Conclusion

It is important that neither a stock split nor a reverse stock split will affect your ownership of the company. The number of shares might increase or decrease, but you essentially control the same percentage of the company as you did before. 

The goal behind stock splits and reverse stock splits is to maintain the attractiveness of the stock among investors.

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