A stock split is where a publicly traded company increases the number of shares available to be purchased in the market . A stock split does not alter the market capitalization of the company, so the stock price must be adjusted accordingly.
What Is A Stock Split?: 2 for 1 split
A 2 for 1 split is a common split. This is where a company doubles the amount of stocks available. If the stock price was $1,000 before the split, the price would be $500 afterwards.
For investors with existing stocks, their stocks would essentially be split in half, so they would own twice as many stocks. They would still own the same proportion of the company.
Ratios for a 2 for 1, 3 for 1 and 3 for 2 are the most commonly seen for stock splits, although any ratio is possible.
Splits of 4-for-3, 5-for-2, and 5-for-4 are used, though less frequently. Investors will sometimes receive cash payments as opposed to taking fractional shares in a company’s stocks.
Why Would A Company Do A Stock Split?
As a stock split lowers the stock price, it would ultimately make the stock more attractive to a wider group of investors. Prior to a split a stock may not have been affordable for many, whereas after, it may be.
A stock split is often seen a positive sign that a company is growing and is likely to continue to grow. As a result a company’s stock price often increases after a split.
It is often stated that stock splits, in and of themselves, lead to higher stock prices; research, however, does not bear this out.
What is true is that stock splits are usually initiated after a large run up in share price, and momentum investing suggests that the stock price would continue to rise regardless of a stock split occurring.
In any event, stock splits do increase the liquidity of a stock as there will most likely be more buyers and sellers for 10 shares of a company’s stock at $20 than 1 share of stock at $200.
Some corporations employ the opposite strategy. When a company refuses to split the stock and keeps the price of purchasing shares high, they lessen trading volume and the volatility of their stock.
Another effect of a stock split could potentially be psychological. If a number of investors believe that a stock split will result in an increased share price and purchase the stock, the share price will tend to increase creating a self-fulfilling scenario where the stock price goes up after a split because people think it will.
Other people believe that the management of a company is implicitly signaling its confidence in the future prospects of the company by initiating a stock split.
Reverse Stock Splits
As its name suggests, a reverse split is where a company decreases the number of available stocks. A reverse stock split is also referred to as a stock merge.
Many stock exchanges require companies to maintain a minimum stock price. If a company’s price goes too low, a reverse split may be needed.
If a company’s stock price is $1, a 5 to 1 reverse split would take the price up to $5. If you already own stock in the company, the number of shares you own would be cut to just a fifth of the amount owned previously. The market capitalization would remain the same.