What Is a Stock Split and Why Do Companies Split Their Stock

What Is a Stock Split and Why Do Companies Split Their Stock

Reading time: 5 minutes

Undeniably, investing in the stock market requires educating oneself. You must contend with a mammoth space with thousands of stocks to potentially invest in. Further, the task of selecting a trading strategy, choosing the right platform, and understanding the plethora of terminology also falls on you, which is a daunting prospect for a new investor.

One important event you must understand is the ‘stock split’. As most know, stock prices rise and fall, but sometimes they split.

Stock Splits?

Two stock splits exist: ‘conventional’ and ‘reverse’.

A conventional stock split is an event undertaken by a public company’s Board of Directors. It increases the number of outstanding shares by dividing current shares into new ones, consequently lowering each share's value by the split ratio.

Suppose Company XYZ opted for a 3-for-1 stock split. Its price initially traded at $10 per share and had 1,000 shares outstanding, meaning its market capitalisation (the total market value of all shares outstanding for the company) was $10,000 (market value is found by multiplying the number of shares outstanding by the current share price). Following the stock split, the company’s share price would fall to approximately $3.33, and each share owned would essentially become three shares, thus bringing the total shares outstanding to 3,000.

Although the number of outstanding shares increases, the company’s market capitalisation (3,000 * 3.33) and the shareholder’s stake remain the same. If you owned three shares of company XYZ before the split, following the event, you would own nine shares at around $3.33 each.

As its name implies, a reverse stock split reduces the number of shares outstanding while increasing the company’s share price. For example, if you owned 100 shares of company ABC and it opted for a 1-for-10 reverse stock split at a market price of $10, you’d now only own ten shares of the company following the reverse split. However, with the company's share price now trading at $100 – as is the case with the conventional stock split – this does not change anything regarding the total value of your investment (it will still be $1,000) or the company’s market capitalisation.

The question, however, is what drives a company to split its stock price.

Drivers Behind Stock Splits

One of the primary reasons companies choose to split their stock price is to reduce their share price, as a high share price can make a stock unaffordable for many investors. Therefore, reducing the stock’s price effectively makes it more affordable for many investors. Following a split, the stock’s liquidity may increase and cause the share price to rally. As there is no guarantee that a stock will appreciate, however, further research is recommended.

A recent example of a stock split is Nvidia (ticker: NVDA). The company announced a 10-for-1 stock split, effective at the close of trading on 7 June. The company’s share price dropped from approximately $1,200 to $120 following the split. At first glance, uninformed investors may have attributed the move to a market crash; instead, this was simply the company undergoing a stock split, enabling more investors to invest.

The reason a company may opt for a reverse stock split is to increase its share price should it have fallen below acceptable levels on the stock exchange it is traded on. Reverse stock splits were common during the 2008 financial crisis. Citigroup (1-for-10 reverse split in 2011) and AIG (1-for-20 reverse split in mid-2009) are two companies that elected for a reverse split some years ago.

Conclusion

News of a stock split can often increase interest in a company, as a stock which would have otherwise been out of reach for some investors (in the case of a conventional stock split) has the potential to become more affordable. Many investors also consider the news of a split as a bullish signal.

However, investors must look beyond the immediate hype and focus on the company's fundamentals. A stock split does not guarantee future stock price growth. Investors should consider the company's financial performance (including profitability, growth, and debt), overall market conditions, and management strategy.

FAQs:

1. What is a conventional stock split?

A conventional stock split increases the number of shares outstanding. This is achieved by essentially cutting up existing shares outstanding and forming additional shares, consequently lowering the value of each share by the split ratio.

2. What is a reverse stock split?

A reverse stock split reduces the number of shares outstanding while simultaneously increasing the price of each share by the split ratio.

3. What are the common reasons a company splits its stock price?

The most common reason for a conventional or reverse stock split is a company’s share price being too high or too low.

Start Trading
in Minutes

bullet Access 10,000+ financial instruments
bullet Auto open & close positions
bullet News & economic calendar
bullet Technical indicators & charts
bullet Many more tools included

By supplying your email you agree to FP Markets privacy policy and receive future marketing materials from FP Markets. You can unsubscribe at any time.




Source - cache | Page ID - 40136

Get instant Updates in Telegram