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What is a Stock Split?
A stock split consists of an action taken by a company to divide its existing shares into multiple shares. The decision to split a stock is usually made by a company’s board of directors.
Stock splits both increase the amount of shares outstanding and decrease the price of shares to reflect the split. Stock splits generally add considerable liquidity to the stock’s secondary market since the split stock will trade at a lower price that tends to attract more investors.
How Does a Stock Split Work?
A stock split takes place when a company decides to divide its existing shares into additional new shares. While the number of shares increases, the total outstanding dollar amount of shares and the company’s market capitalization will generally stay constant since the split does not add any value to the shares.
Stock splits typically take place when a stock’s price has risen to a point that has made the stock less liquid and has caused investor interest to wane due to the high price, since high priced stocks usually have a lower traded share volume and less public participation.
When a stock split takes place, the stock’s lower price makes it more accessible to investors with less money. Splits also boost trading volume and tend to increase liquidity in the stock.
In a stock split announcement, a company will let the market know the ratio of the stock split and the day when it will occur. On the day the stock splits, the original shares trading on the relevant stock exchange will open at an adjusted price.
Stock Split Examples
The most common stock splits are 2 for 1, 3 for 1 and 3 for 2 shares of stock, although a stock split could instead be 5 for 1, 10 for 1, 5 for 4 or whatever ratio the company’s management and board of directors decide upon. The examples below explain how the most common stock split ratios work:
- 2 for 1 split: The simplest stock split is the 2 for 1 split, where you multiply the amount of outstanding shares by 2 and divide the current price of the stock by 2. For example, if you own 100 shares of XYZ stock that currently trades at $20 per share, after the stock split, you would own 200 shares of XYZ worth $10 per share.
- 3 for 1 split: In a 3 for 1 stock split, for every share someone holds, they will own 3 shares after the split. After such a stock split, you multiply the number of outstanding shares by 3 and divide the current stock price by 3. For example, if you own 100 shares of XYZ stock that currently trades at $20 per share, you would multiply 100 by 3 and divide $20 by 3, leaving you with 300 shares at $6.66 per share.
- 3 for 2 split: In a 3 for 2 stock split, for every 2 shares a shareholder owns they will own 3 shares after the split. After such a stock split, you would multiply the number of outstanding shares by 3 and then divide that number by 2. You would also multiply the share price by 2 and divide the result by 3 to get the new share price. For example, if you own 200 shares of XYZ stock at $20 per share, after the split you would own 300 shares of XYZ stock at $13.33 per share.
What is a Reverse Stock Split?
A reverse stock split occurs when a company decides to reduce its outstanding stock amount without changing shareholder’s equity. Reverse stock splits generally occur when a stock’s price has declined considerably, so they serve to consolidate the company’s outstanding stock into fewer shares that are each worth more.
The most common reverse stock splits are 1 for 5 and 1 for 10 shares of stock. For example, in a 1 for 10 reverse stock split, a person previously holding 1000 shares of XYZ stock at $1 per share would wind up holding 100 shares at $10 per share.
Reverse stock splits help companies avoid having their stock delisted from major exchanges that have minimum prices for listing. Such splits also signal that a company might be in dire straits, so check the company’s finances carefully when considering buying stock in a company that has recently done a reverse stock split.
Do You Lose Money on Stock Splits?
A company typically splits its stock because it has risen significantly in price, so a stock split is done both to increase liquidity and to make the stock available to a wider range of investors.
Since only the number of shares and their price are affected in a stock split, the dollar value of your stock holding would not be affected by the split. This means you should not lose any money just because of the split.
For example, if you own a stock that is about to do a 2 for 1 split, then you will end up with the same dollar amount of stock but double the amount of shares where each share is worth half its initial value.
Furthermore, stocks that split also tend to increase in value since they are now available to more investors. Of course, whether you’ll make money on a split stock depends on a number of circumstances unique to each company’s situation and the stock market as a whole.