What Is a Stock Split?

You may have read about stock splits in the news. Big, successful corporations sometimes split their stocks multiple times. But what does a stock split actually mean about the company, and what does it mean for shareholders? If you get word that a company whose stock you own is splitting its stock, don’t panic. We’ve got you covered with our guide to stock splits and reverse stock splits.

Stock Splits: A Definition

A stock split lowers the price of shares without diluting the ownership interests of shareholders. Take, for example, a 2-for-1 split. A shareholder would go from owning, say, 200 50-dollar shares to owning 400 25-dollar shares. If you’ve done the math, you’ll have figured out that the total value of the shareholder’s stock is the same. The shareholder isn’t losing money and isn’t losing market share relative to other shareholders. If the stocks pay dividends, the dividends per share will decrease by the same proportion as the price, but the total dividends earned will be unaffected. That’s why, from a shareholder’s perspective, a stock split is nothing to sweat.

Why Do Companies Split Stocks?

There are several reasons a company might decide on a stock split. For one thing, a stock split lowers prices, which can re-introduce some liquidity into the market for the company’s shares. Announcing a stock split is a signal to the market that the company is doing well enough for its shares to have gotten expensive. It’s a sign of strength. But it also helps highly valued companies compete with other companies in the same industry whose shares are more affordable.

Because the stocks are less expensive after the split, the company has a better chance of attracting new buyers at the more accessible price point. Big, successful companies may split their stocks several times. That increases the number of outstanding shares and allows more investors to get in on the action.

How Do Stock Splits Work?

When a company decides on a stock split, it can choose the ratio of the split. A company can split a stock any number of ways, but common ratios are 2-for-1, 3-for-1 and 3-for-2. Once the stock split is in place, the price of the shares will adjust automatically in the markets.

If a company decides for a 2-for-1 stock split, for instance, each shareholder who owned a stake prior to the split will now own twice as many shares. However, each shareholder’s percentage stake in the company remains the same. While each shareholder now owns twice as many shares in the company, the company also now has twice as many shares available. The total dollar value of investors’ shares also remains the same. Because each stock was split in two, each stock’s share price was also roughly divided in half.

Are Stock Splits Good For Investors? 

If you’ve been eyeing a certain company but you’ve been priced out of buying their stocks, you may get your big break if the company decides to do a stock split. But it’s important to know that a stock split isn’t necessarily a sign that the company will continue to do well, or that the company’s stocks will become more and more valuable in the future.

Repeat after us: past performance is not an indicator of future results. Just because a company’s share prices rose enough for the company to split its stock doesn’t mean that price growth will continue. That’s the thing about investing – it’s hard (some say impossible) to beat the market. Even professionally managed funds tend to under-perform index funds. If you’re still eager to buy shares in a certain company, you can easily look up that company’s historic stock splits. You can also contact the investor relations department of most major companies to get a complete history of their stock splits, or find a financial advisor to talk to.

Moreover, it’s important for existing shareholders to remember that while they own more shares after a stock split, the overall value of their holdings will remain the same. The company’s worth will also remain unchanged.

What Is a Reverse Stock Split?

A reverse stock split does the opposite of what a regular stock split does. In a reverse stock split, a company reduces the number of shares, driving up the price of each share. You might go from owning 10,000 shares to owning 1,000 (after a 1-for-10 split), but the value of your holdings will stay the same. Why? Because like a forward stock split, a reverse stock split doesn’t change ownership proportions and doesn’t affect the proportional value of dividend payments.

So why would a company consolidate its shares with a reverse stock split? By raising share prices, a reverse stock split may help a company meet the requirements for trading on a major exchange. If share prices dip too low, a company could be booted from an exchange and lose access to investors. A reverse stock split elevates share prices, helping a company stay listed.

Plus, a company may think that its share prices are too low to attract investors. Just as owners of successful companies may feel that their share prices are too high to draw investors, owners of other companies may feel that their share prices are too low, repelling potential investors who may think that the company isn’t worth investing in.

Bottom Line

If you receive notice that a company whose shares you own is doing a stock split, rest assured that the value of your shares won’t change. The money you invested won’t disappear. Investing in the stock market has risks, but a stock split isn’t generally one to lose sleep over. If you invest through a brokerage, you should automatically receive credit for extra shares after a stock split. If that doesn’t happen, contact your brokerage firm. As a bonus, you may see share prices rise after a stock split, as more investors become interested in the company’s shares. That would increase your net worth and bring you a little closer to retirement readiness.

Tips for Investing in Stocks

• Keep your emotions in check. It can be easy to panic when you see the markets take a huge downturn, but that can lead to the mistake of buying high and selling low. If you’re not sure you can stomach the ups and downs, consider finding a financial advisor to oversee your portfolio.
• Diversify your investments. By diversifying, you’ll be better able to manage your portfolio’s risk, as your eggs won’t all be in one basket. SmartAsset’s asset allocation calculator can help you determine the allocation that best aligns with your risk tolerance. For instance, a moderate investor’s portfolio should only contain about 65% stocks.
• Create an investing plan for yourself. Before you dive into investing, it’s a good idea to know why you’re buying and what your time horizon is. In general, financial advisors recommend investing for the long term. This will allow you to reap the benefits of investment growth over time.

Photo credit: flickr, ©iStock.com/Mikko Lemola, ©iStock.com/Henrik5000