One of the more confusing concepts to grasp for many investors just starting out is the stock split. The investor may own some shares of a stock, and they suddenly notice that the number of shares they own has increased, but the price of the stock has decreased. The investor just experienced a stock split.
A stock split is considered a corporate action. All that means is that the split is an event that is put into motion by the company. In most cases, the company's Board of Directors authorizes a stock split.
When a company splits its stock, it is increasing the number of shares while reducing the price of the stock. The most common type of split is a two-for-one split. When this occurs, the number of shares traded is increased by two times and the price of the stock gets cut in half.
The most important fact about stock splits to understand is that splits really do not have any financial impact. Let's look at an example. The Board of Directors of ABC Industries decides to split its stock two-for-one. What does that mean? If the company had one million shares of stock trading before the split, it will have two million shares trading after the split. In addition, the price of the stock will decrease by half. So if the stock was trading at $50 before the split, then it will begin trading at $25 after the split.
If you multiply the number of shares by the price of the stock before and after the split, you will see that the market value, or the total value of the company's stock, remains exactly the same. Before the split, the market value of the stock was $50 million (one million shares times $50 per share). After the stock split, the market value is still $50 million (two million shares times $25 per share).
A stock split does not affect an investor's total position value. Assume an individual investor owns 100 shares of ABC Industries' stock before the split. The position value is $5000 (100 shares times $50 per share). After the split occurs, the investor will have 200 shares, but the price of the stock gets cut in half to $25. The position value after the stock split is exactly as it was before the split (200 shares times $25 per share, which is $5000).
While two-for-one splits are the most common type of split, splits with other ratios can occur. Three-for-one splits increase the number of shares by three times and reduce the price of the stock to a third of its pre-split price. Another common split is a three-for-two split. In this type of split, the investor will have three shares of the stock for every two shares they owned before the split. So if an investor owned 100 shares pre-split, then they would own 150 shares after the split.
As mentioned earlier, stock splits do not have any financial impact since the total market value remains the same. If that is the case, then why would a company split its stock? The main reason behind stock splits revolves around psychology. When a stock's price gets high, many investors, especially retail investors, feel that they cannot afford the stock. The aim of the stock split is to make it seem as if the stock is more affordable to encourage people to invest in it.
Does a stock split help a stock's performance? In theory, a split should have no impact on the performance of the stock, since it is a simple corporate action that has no financial consequences. With that said, investors are humans who have emotions, and the psychology surrounding a stock split can in some instances help the performance in the short term. Individual investors may think they are getting a bargain on a stock after it splits, causing them to purchase shares, which in turn leads to price gains. This phenomenon is typically short-lived, and the forces of the stock market will typically bring a stock in line with its fair value within time.
Besides traditional stock splits which increase the number of shares and reduce the price, there is another type of stock split called a reverse stock split. Reverse stock splits decrease the number of shares while increasing the stock price, which is precisely the opposite of a traditional stock split. Let's assume XYZ Corporation has ten million shares available, and the shares are trading at $0.50 per share. The Board then authorizes a one-for-ten reverse split. There will be one million shares available after the split, and the share price will increase to $5.00 per share.
Like traditional stock splits, reverse stock splits do not have a financial impact. The market value of the stock remains the same, only the number of shares and the price of the shares has changed.
A company's main motivation to issue a reverse stock split is to fall into compliance with stock exchange regulations. Many stock exchanges will not allow a stock to trade if its share price remains below a certain level for an extended period of time. The reverse stock split will increase the stock price above the stock exchange's minimum, thus allowing it to continue to trade on the exchange.
While stock splits can be confusing for the novice investor, the most important thing to remember is that splits really do not have any monetary consequences. Splits are just financial engineering that companies use. The market value of a stock position is unaffected by the split.