A stock split is a very common action performed by companies in order to increase liquidity in their stock. If you’re an investor it’s important to understand the different types of stock splits that exist and their implications.
Summary
- A stock split divides the existing shares of stock into new shares to improve the stock’s liquidity and decreases the stock price
- The total dollar value of the new total shares held remains the same
- Common stock splits include 2-for-1, 3-for-1, 4-for-1, 5-for-1, 10-for-1
- A reverse stock split decreases the number of outstanding shares and increases the stock price
What is a Stock Split?
A stock split is a corporate action performed by a company that divides the existing number of shares of its stock into new shares. This is done without diluting the value of the shares held by investors to increase liquidity in the stock.
A stock split will increase the total number of shares outstanding and lowers the individual value of each share. The total dollar value of the shares remains the same after the split, as the split does not give additional value to the shareholder, simply more shares
How Stock Splits Work
A standard stock split is referred to as a forward stock split. If a company announces a stock split the current shares get divided into more shares. A standard stock split lowers the trading price of the stock and increases the liquidity of the shares.
A lower stock price can help to make the stock more accessible for smaller investors. If the price of a stock has gone up significantly, it’s normal for companies to issue a stock split. This is done to reduce the price down to one that is more suitable for retail investors.
When a stock split is done, the price of the shares adjust automatically. Some of the most common stock splits include:
- 2-for-1
- 3-for-1
- 4-for-1
- 5-for-1
- 10-for-1
A 4-for-1 stock split means that for every share held by an investor, there will now be four. So, if you previously held 100 shares of Apple stock and they issued a 4-for-1 stock split, you will now have 400 shares of stock. If the price of the stock was previously $100 per share, it will now be reduced to $25 per share.
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The dollar value of your shares remains the same while the number of shares you hold increases. This also means that the number of outstanding shares will quadruple. Stock splits help to introduce new liquidity in a stock.
What is a Reverse Stock Split?
A reverse stock split is the opposite of a forward stock split. If a company announces a reverse stock split, it will decrease the number of outstanding shares and increase the stock price. Just like a forward stock split, the dollar value of the overall stock position remains the same with a reverse stock split.
A common reason companies do reverse stock splits is to stay above the minimum stock price required by exchanges in order not to get delisted. If a company fails to meet a minimum closing bid price of at least $1 for 30 consecutive trading days it can trigger a delisting from the exchange. If this happens the stock will be traded on the OTC market.
For example, let’s assume you owned 100 shares of XYZ stock at $100 per share and the company decided to issue a 1-for-4 reverse stock split. In this situation, you would have 25 shares at $400 per share. The dollar value of your shares decreased by 4 times and the price of the stock went up by 4 times.
Why Do Companies Do Stock Splits?
Now that you know the two different types of stock splits that exist, it’s important to know why companies do forward stock splits and why companies do reverse stock splits.
Why Companies Do Forward Stock Splits?
The main reason companies do forward stock splits is to reduce the trading price of a stock to make it more liquid and affordable for investors. If the price of a stock is over $500 per share, it might deter smaller investors from getting in.
If that stock price is $100 per share, it’s more affordable for investors to participate. For the most part, a forward stock split is often a sign that a company is doing well and that its stock price has gone up significantly, but in that process, it has become less affordable for investors.
Why Do Companies Do Reverse Stock Splits?
One of the main reasons companies do reverse stock splits is to avoid getting delisted from a stock exchange. If the share price of a stock is approaching the minimum share price allowed to be listed on an exchange, they may look to do a reverse stock split.
Another reason that companies do reverse stock splits is to improve the perceived value of their stock from a public standpoint. This is common in order for companies to attract new capital for a stock.
How do Stock Splits Impact Short Sellers?
Stock splits don’t have a negative impact on short sellers. It is however important to note that there are underlying fundamental changes as a result a stock split. Although splits don’t impact the dollar value of the short position, the amount of shares short increases.
If you’re shorting a stock, you’re borrowing the shares with the agreement that you will buy them back later.
Let’s assume you shorted 100 shares of XYZ stock at $40 per share and they undergo a forward stock split of 4-for-1. As a short seller you would now be short 400 shares at $10 per share and have to buy back 400 at at a future date.
Should You Invest In A Company After a Stock Split?
This will depend on the type of stock split that was done. If you’re thinking about investing in a company following a stock split, it can present a great opportunity. Apple stock has split 5 times since the company went public in 1980. It has been one of the most profitable stocks for investors in history.
It’s important to know what stock you are purchasing and the reason behind the stock split. For companies like Apple, stock splits are historically common and have been extremely profitable for investors.
FAQ’s
What Happens If You Own Stock and It Goes Through a Stock Split?
If the company has gone through a forward split, you will receive more shares depending on the ratio split and an adjustment in the share price. If the company has gone through a reverse-split you will get less shares with a higher adjusted stock price.
Will a Stock Split Impact My Taxes?
Stock splits do not create any sort of taxable event, you simply receive more shares at a lower price.
Do Stocks Usually Go Up After a Split?
Depending on the type of stock split that took place, the price of the stock can go up if the market views it as a positive event.
