While a stock split doesn’t change the value of your investment, it’s generally a good sign for investors. In most cases it means that the company is confident about its position going forward, and that it wants to seek additional investment.
A stock split usually makes it easier for your investment to gain value — though it generally doesn’t mean a sharp increase right away.
For help managing your own stock portfolio, consider working with a financial advisor.
What Is A Stock Split?
A stock split occurs when a company changes the number of shares it has in circulation without changing its overall market capitalization. Stock splits come in two main categories:
The overwhelming majority of stock splits are forward splits. In fact, this is almost always what someone is referring to when they generally refer to a “stock split.”
In a forward split, the company increases its stock in circulation. It divides each share into several new shares, which multiplies the number of shares in circulation. Everyone who owns stock in the company receives new shares based on their current investment. However, the stock price also divides by the same ratio, so the company’s market cap and the value of any given investment remains the same.
For example, say you own 10 shares of stock in ABC Corp. It is currently trading at $100 per share, giving you a $1,000 overall investment in the company. ABC Corp. decides to execute a 4-1 forward stock split.
This means that ABC Corp. will issue four shares of stock for every one share outstanding before the split. The stock’s new price will be $25 per share (the original $100 share price divided by four), retaining ABC Corp.’s overall market capitalization. You, as an investor, would receive four shares of stock for every one share that you owned prior to the split. This would leave you with 40 shares each worth $25 per share.
A reverse split is relatively rare. In reverse splits, the company consolidates the number of shares outstanding. In the same way as a forward split, it maintains the company’s overall market cap by changing the share price relative to the number of shares in circulation. However, here prices increase based on the split ratio.
For example, say that ABC Corp. currently trades for $10. It announces a 2-1 reverse split. This means that it will issue shareholders one share of stock for every two shares that they owned before the reverse split. Each share will be worth $20 (the original $10 share price times two).
What Happens to Options?
The short answer is not much. After a stock splits, share prices are adjusted to keep the value of the total number of outstanding shares unchanged. That could cause the value of options on affected shares to change dramatically. To avoid that, options – whether call or put – on stocks that split are adjusted so that the split doesn’t change the value of the options. The option contract adjustments are handled automatically by the options clearinghouse.
For instance, if an investor has an option for 100 shares of stock with a strike price of $10, after an adjustment for a 2-for11 split, the investor will hold two options. Each option represents 100 shares with a strike price of $5. The adjustment is done automatically by the Options Clearing Corporation (OCC), a derivatives clearinghouse. Investors don’t have to do anything to keep the value of their options unaffected.
Reasons for a Stock Split
The main reason for a stock split is to adjust the company’s share price without changing its overall market capitalization or ownership ratios. A company can reduce its share price by issuing new stock, but that would require selling more ownership in the underlying firm. It can increase that share price by buying back its own stock, which takes ownership off the market. In both cases, however, this adjusts the company’s market capitalization and ownership percentages.
A stock split allows the company to change its share price without changing that overall market capitalization or private/public ownership ratio.
Forward stock splits occur when the company decides that its share price has gotten too high. Often, the company wants to lower that price to draw in more investors. Higher share prices can deter investors, so the company executes a stock split to make its shares more accessible. This often allows room for further, faster growth than the company might have achieved otherwise.
With a reverse stock split, the company might want to increase the perceived value of its stock. By consolidating shares, they increase their price per share, which is often done to stabilize an overly volatile asset. By raising share prices the company might slow down trading, and the stock’s price is less subject to small-dollar fluctuations.
Are Stock Splits Good?
A stock split is neither inherently good nor bad. Again, after the split itself your position as an investor remains unchanged. You own a different number of shares, but the value of your investment remains the same.
However, stock splits often do lead to portfolio growth.
With a forward split, the biggest advantage is that your shares can gain value more quickly. New investors can buy in more easily, allowing for faster potential growth in the company’s share price. That growth is also magnified, since you hold more shares than you used to. Forward splits also tend to correlate with success, in large part because most companies do this when things are going well.
Perhaps most importantly, it’s easier for your shares to proportionally grow. For example, a $10 stock only needs to gain another $10 in value to double your investment, while a $100 stock needs ten times the gains to post the same investor results. This can lead to much stronger portfolio growth, although of course the reverse is also true. A $10 stock only needs to lose $5 in order to cut the value of your investment in half.
Reverse splits are trickier. Companies often execute a reverse split on volatile or otherwise weak assets, so they don’t tend to correlate with strong performance as much as a forward split. However, a reverse split can do a lot to stabilize a volatile asset. In the same way that it’s easier for a lower-priced stock to double or halve in value, a higher-priced stock has much more buffer against that kind of low-dollar movement.
The Bottom Line
Stock splits occur when a company changes the number of shares in circulation without changing its overall value. Such splits can be forward or reverse. The former increases the number of shares an investor holds; the latter decreases the number of shares an investor holds.
The result is that every shareholder receives a new number of shares proportional to their ownership in the firm, and each share has a new price based on the company’s market cap.
Stock Investing Tips
- A reverse stock split might be more rare than a forward one, but it’s also potentially much more complicated. If you’re invested in a company that has executed one, it’s a good sign to start paying close attention.
- A financial advisor can help you create a strong stock portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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