An Overview of Stock Splits

A stock split is when a company issues more shares of additional stock to current shareholders, thus lowering the price of each share.

The most common types of stock splits are “2-for-1” and “3-for-1.” For example, if a shareholder owns 10 shares of stock worth $100 ($10 per share) and the company decides to do a 2-for-1 stock split, the shareholder then owns 20 shares of stock worth $100 ($5 per share) after the split.

Top reasons why companies perform a stock split

Companies can decide to perform a stock split for several reasons, but the most common impetus is the ability to raise additional capital more easily. This is often the case when a company’s stock price is too high for the average investor and/or investors fear there is little room for growth. A stock split makes the share price more enticing, boosting the chance additional people will invest in the company.

Another popular reason is to increase liquidity, as a stock split can make it easier for investors to trade their stocks: because the more expensive the stock is, the longer it can take someone to sell his or her shares.

Why some companies don’t split stock, and potential negative impacts

Not all companies split their stock, as there is sometimes no compelling reason to do so. Others believe a higher stock price can give their company an air of prestige with perceptions of value outshining lower-priced stock. Berkshire Hathaway is probably the best example of this, as their Class A shares have never split and are valued at nearly $500,000 per share—although the company does offer Class B shares (with fewer voting rights) so investors can also purchase shares at reasonable prices.

Stock splits do involve potential risk, especially if an unexpected financial event (such as a recession or other news that adversely impacts the company) follows quickly thereafter. Why? Because this will likely drive down the price per share even more. In such a scenario, the rapid fall in price may spook investors and/or—in worst-case scenarios—tumble below the exchange’s listing requirements, removing the company from the stock exchange and limiting the ability to raise capital.

Reverse stock splits

Companies can also do the opposite and replace existing shares with a proportionate number of smaller shares: something known as a “reverse split.” For example, a 1-for-2 reverse split replaces two of your existing shares with one new share—meaning that if you owned 100 shares of stock, you’d now own 50 shares at the same overall value.

Companies with low share prices often conduct reverse stock splits when facing the risk of an exchange delisting for not meeting the minimum price. In taking this action, they can boost their share price and remain listed on the exchange.

Reverse/forward stock splits

While less common, a company that wants to reduce the burden and administrative cost required to communicate with every investor may decide to eliminate smaller investors through what’s known as a “reverse/forward split.”

In doing so, the company performs two different stock splits: a reverse split conducted to reduce the overall number of shares (causing some shareholders who hold less than minimum requirements to cash out) followed by a split that increases the overall number of shares each shareholder owns.

Other details to know about stock splits

There are three important dates associated with stock splits. The first is the “announcement date” when the company shares all related details, including the split ratio (e.g., 2-for-1 or 3-for-1). Existing shareholders must own the stock on the “record date” to become eligible to receive new shares created by the split. Finally, the “effective date” is when the stock split occurs and the new shares hit investor accounts.

Depending on the trading platform (e.g., Robinhood, Stash, or SoFi Invest), you can now specify how much money you want to invest in a particular company—rather than how many shares you want to buy. For example, if you want to buy a stock valued at $1,000 but only have $200 to spend, you can buy one-fifth of a share. This is called “fractional investing.” As this strategy gains steam, it’s not preposterous to assume this will reduce the need for stock splits.

What a stock split means to the investor

A stock split doesn’t change anything on a material basis for existing investors, as they remain in the same exact position they were before—meaning the percentage of their ownership hasn’t changed. While they’ll own more shares, each will represent a smaller percentage of ownership within the company.

That said, it is common to see demand for a stock rise post-split given more affordable shares. A bump in value may result, but these increases are generally short-lived.

The bottom line on stock splits

Any type of stock split has little, if any, impact on existing shareholders. However, these lower stock prices are sometimes very enticing to prospective investors.

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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.