A stock split is when a company issues more shares to current shareholders to increase the number of outstanding shares and decrease price.
Understanding stock splits
When a stock’s price has a significant drop, it’s not always due to a loss in value. It can be due to a stock split.
The purpose of a stock split is to lower the price of each share while maintaining the market value of the company.
It’s achieved by issuing more shares to existing shareholders and lowering the price of each share.
This increases the number of outstanding shares, lowers the share price, and the market value remains the same.
Since the stock price is lower, it becomes attractive to investors that weren’t able to purchase a share before the stock split.
Related article: Earnings per share (EPS) definition and formula
Your portfolio may benefit from an increase in market value because the board of directors is trying to attract more investors by lowering the price and increasing the number of shares available.
How it works
When the price of a company’s individual stock becomes too high, they may consider a stock split. It also occurs if the price becomes much higher than its competitors.
If the price of a stock is too high, investors can no longer afford to buy more shares. Therefore the number of people that are and can buy shares decreases. This can affect liquidity.
Liquidity is important because it allows shares to be purchased and sold without making a big impact on the price.
Stock splits must be voted for by the board of directors and approved by shareholders.
To qualify for the stock split, you’ll need to be a shareholder by a certain date, which the company specifies.
The most common types of stock splits are 2-for-1 and 3-for-1. Depending on the type, it means you’ll have two or three shares for every one share that was held.
For example, Company A announces a 3-for-1 stock split, and you own 50 shares priced at $150 per share. The total value that you own is $7,500.
After the 3-for-1 stock split, the $7,500 total value will remain the same. However, you’ll now have 150 shares, and each share will be worth $50 instead of $150 (divide 150 by 3).
Types of stock splits
There are two types of stock splits, forward and reverse.
A forward stock split is when a company increases the number of outstanding shares by issuing current shareholders. It’s done to lower the price of each one.
A reverse stock split is when a company reduces the number of outstanding shares and increases the price of each one.
Regardless of the type of stock split, the market value of the company will remain the same. The changes occur to the number of shares and the price.
Stock splits can be beneficial for companies that are priced higher than their competitors and have noticed decreasing trading volume. As an investor, stock splits won’t add or reduce the value of your portfolio. Instead, you have the potential to reap the benefits as investors begin to invest in the company.
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About David Em
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.