Would it make any difference to you if someone were to hand you two $10 bills, rather than a $20? Probably not, right?
This concept helps explain something called a ‘stock split’ in the investing world. Unlike this example, however, stock splits do cause excitement for investors. What is a stock split, you ask? Keep reading and you’ll find out what it is, why companies do it, and why you should know about it as an investor.
What Is A Stock Split?
A stock split is an action taken by a publicly-traded company to increase its number of outstanding shares. This decision is made by a company’s board of directors.
The number of outstanding shares is increased by issuing more shares to current shareholders. Splitting the stock doesn’t change the company’s market capitalization. It also doesn’t affect the total value of shares for investors.
Continuing with the example from above, let’s say an investor acquired a $20 bill from a company. In this case, the $20 bill represents a share. Then, the company takes the bill and hands back two $10 bills instead. The investor still owns shares with the same value, but now has two shares instead of one. In this specific example, this is called a 2-for-1 stock split. What are the different types of stock splits? The most common types you’ll hear about are:
Stock Split Examples
If you’re not sure what your new stock price is after a split, a little arithmetic can help you figure it out. Simply take your previous stock price and divide it by the split ratio. Let’s say you had one $20 share. Here is a 2-for-1 stock split example:
The new trading price per share is $10.
Let’s use the same example, but say it’s a 3-for-2 stock split this time. To do this, you would take:
The new trading price per share is $13.33.
Why Would A Company Do A Stock Split?
You might be wondering why a company would go through the trouble of doing a stock split. The core reason is to influence market behavior.
If a stock price gets too high, some investors may feel as though it’s priced too high to buy. Others will feel that it’s unaffordable. By splitting the stock, the company can bring down the price of an individual share. This makes each share more affordable. Keeping in mind that the value of the stock remains unchanged, you could argue that this is a psychological tactic. By bringing the price down, the company can attract new investors. They can also give existing shareholders the feeling that they have more shares than before.
Another reason a company would do a stock split is liquidity. In some cases, stocks can trade with a bid/ask spread of over $100. A bid/ask spread is the difference between a stock’s bid and ask price. If the highest price of a buyer is willing to pay for a stock is lower than what a seller will accept, things can quickly get stagnant. By splitting up the stock, the company can encourage some movement in the market.
Again, from a value perspective, stock splits make no difference whatsoever. However, it is a great tool for influencing trader behavior. CNN Business provides coverage on why the high-profile company Tesla conducted a stock-split just months ago.
Stock Splits & Short-Sellers
Stock splits don’t have a significant impact on short sellers. (A short seller is someone who predicts a decline in a stock. They will borrow that same stock and sell it on the open market, with a plan to buy it at the cheaper price all along.)
Remember, stock splits don’t affect the value of a stock. The changes to note are the number of being shares and the price per share.
Let’s say a short-seller owes 50 shares to the lender. The company then splits the stock 2-for-1. Now, they owe 100 shares instead of 50. If they predicted correctly, they can now buy 100 shares at a cheaper price and return them to the lender for a profit.
Keep in mind that short selling is a market prediction game and should only be used by advanced traders.
Advantages Of A Stock Split For Investors
If you’re an investor, it’s critical to do some research and find out why the company is doing a stock split. Then, you can decide whether it is to your benefit or not. If stock prices are increasing to the point that a stock split is needed, then it could be a signal that the company is doing well. On the other hand, it could be that the company simply needs more liquidity.
If you’re an existing shareholder, a split doesn’t affect you at all. It might feel exciting to double or triple your number of shares. However, you need to keep in mind that the value hasn’t changed at all.
If you’re an investor who’s been waiting to get in on a company but hasn’t been able to afford a share, then a split could be good. After a split, the price of an individual share should be much more affordable. Your share will only be half the value of what it was before a split, but at least you’ve got your foot in the door.
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What Is A Reverse Stock Split?
A reverse stock split is when a company decides to consolidate the number of outstanding shares. Instead of increasing the number of outstanding shares on the market, the company is decreasing it. You will also hear traders referring to this as a stock consolidation, stock merge, or share rollback. In our examples, the split ratios looked like 2-for-1 or 3-for-2. In a reverse stock split, the consolidation ratios take the total shares by a number like 5 or 10. So the reverse split would be called a 1-for-5, or 1-for-10, respectively.
Reverse Stock Split Example
Here’s an example to help drive home how a reverse stock split works. Let’s say Company X has 20 million outstanding shares in the market. Each share is currently trading for $10 per share. Company X wants to merge or consolidate 5 outstanding shares into 1 share. This is called a 1-for-5 reverse stock split. Once the reserve split is done, Company X will have 4 million shares.
The 4 million consolidated shares will now cost $50 each to trade ($10 x 5) = $50.
Reverse Stock Split Advantages
It may come into question why a company would do a reverse stock split, but it does come with its advantages. A reverse split reduces the number of issued shares without changing the total value of the shares issued. As a result, you may own fewer shares but each share is worth more than the original.
A reverse stock split is usually done for policy-based reasons. First, exchanges such as NASDAQ have listing requirements such as a minimum bid price. If a company’s share price has gotten really low, a company might do a reverse stock split to increase its share price to meet minimums. Otherwise, they might risk getting delisted from the exchange, thus making their stocks less attractive.
Mutual Funds and other types of investment firms also have policies where a share must have a minimum value. A company might use a reverse stock split as a tool to maintain their position in these types of funds.
Finally, a company will do a reverse stock split to reduce the number of shareholders. They might do so if they want to go private, or in preparation of creating a spinoff company.
A stock split is a common strategy used by companies to lower their price per share by increasing their number of outstanding shares. A reverse stock split is enacted by companies that want to do the opposite, which is to increase their price per share by consolidating their number of shares. Investors should keep in mind that splits don’t have any impact on the value of the company’s stock. On the plus side, it might be just the opportunity you needed to get in on some stocks that were too expensive prior to the split. It’s always important to investigate why the company decided to split or reverse stock split, and then determine whether or not it’s to your advantage. If you had the question, “what is a stock split,” then now you have your answer.
Did you ever experience a split that boosted your investing game? Share your story in the comments below!
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