Sometimes, a company’s stock price might rise significantly, to the point that it’s too high for new investors. In response, the company’s board of directors may announce a stock split – a phenomenon that leads to an increase in the number of shares available for purchase. It also reduces the price of each share.
Here’s everything you need to know about a stock split.
How does a stock split work?
A stock split is the process of reducing the face value of a company’s shares by dividing one share into two or more parts.
A stock split changes both the number of shares you own and the price of those shares, so that the total value of your investment is exactly the same as it was before. The only difference is that the number of shares you own changes.
The process begins with a company announcing the date it plans to split its stock as well as the date on which you must own the stock to be eligible for the split.
A typical stock split works on a simple ratio, with a 2-for-1 ratio being the most common. A 2-for-1 split gives every investor twice the number of shares, each at half the original price.
If, for example, a share price has reached £200 and the company declares a 2-for-1 stock split, it means that the stock price is halved to £100, but you get 2 shares each worth £100 instead of the original one share at £200. The total value of your investment doesn’t change, but the value of each share is halved.
Companies can use other ratios to split their stock. The ratio used depends on how high the price of a share has become. It may also depend on the new low share price that a company wants to set.
Why do companies split their stock?
A company may split its stock for a variety of reasons. One reason, is that a split increases the number of shares in the market. This means that in time, more people will own a part of the company.
Having more investors is desirable because it creates more interest in a company as well as its stock. In turn, this may drive up the stock price and get more capital invested into the company.
For example, on 31 August, both Apple and Tesla split their stocks at the ratio of 4-for-1 and 5-for-1, respectively. After the split, Apple’s share price jumped over 3.4% and Tesla’s rose by 13%, as reported by Bloomberg. This was as a result of both splits attracting more investors.
Another reason for a stock split is that increasing the number of shares reduces the price per share. This means that more people, including everyday investors, are able to buy shares.
What’s the benefit to an existing shareholder?
As an existing shareholder, the primary benefit of a stock split lies in seeing your shares’ price go up.
Using the previous example, if the value of each share goes up by £10, the original shareholders will have two shares valued at £110 each. So, without investing any new money, the original shareholders will now have £220 instead of £210. This stock price increase wouldn’t have occurred if not for an influx of new investors after a stock split.
If you remain a shareholder in an established blue chip company, you may experience several stock splits, and your number of shares will keep increasing.
What is a reverse split?
A stock split can also work in reverse. Here, a company announces that investors will now get one new share for so many of their existing shares. The goal of a reverse split is to reduce the number of shares but raise the share price in the same ratio.
Usually, a reverse split is a bad sign that a company might be in financial trouble. A company may initiate a reverse split if its share prices fall to a level so low that it risks being delisted from an exchange for failing to meet the minimum share price required for listing.
In many cases, a reverse split means that the company has done almost everything it can to improve its financial position but has failed to stop the progressive decline of its share price because of active selling by investors who have most likely lost hope in its ability to recover.
A lot of investors actually bail out of a company once they discover that such a split is imminent.
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