What is a Stock Split?
A stock split is a corporate action that increases the number of outstanding shares of a publicly traded corporation. This is done by multiplying the total number of outstanding shares by a specific factor—usually two or three.
Stock splits impact share price, liquidity, and the number of shares that each investor owns, but they do not impact the overall valuation of the company or the value of an investor’s portfolio position.
Why Perform a Stock Split?
The decision to split a stock comes from a corporation’s board of directors. The most common reason boards decide to split their stock is to increase liquidity by decreasing the stock’s share price.
This is often done when the share price is too high to appeal to smaller retail investors or when the share price has outpaced the price levels of other companies in the same sector.
For example, if ABC Corp. has a share price of $650 and decides to execute a 4-for-1 stock split, each investor who holds ABC will see the number of ABC shares they own quadruple and the per-share price reduce by seventy-five percent.
Their position size, at the time of the split, will remain unchanged. It is also important to note that the company’s market cap and valuation remain roughly unchanged as well.
Let’s say that you own 1,000 shares of ABC when the stock undergoes a 4-for-1 split. Your portfolio would reflect the following changes.
Note that at the time of the split your position size hasn’t changed. Investor behaviors immediately following the split can change the share price, however, and these changes can impact position size.
What Do Stock Splits Signal to Investors?
Immediately following a split, share prices often rise. This is due in part to two key factors: accessibility to new investors and the presumption of further growth.
The sharp and sudden decline in share price resulting from the split often has the intended effect of encouraging investment by smaller retail investors. By jumping on the newly price-reduced shares, this wave of buyers reduces the total number of outstanding shares and increases the share price.
The second factor in increasing share prices due to investor behavior following a split is the presumption of further growth. Investors assume that the reason the share price was high enough in the first place to warrant a split was because of business growth.
If that trend will be continuing and the shares are recently discounted, why not load up?
Reverse Stock Splits
A reverse stock split is the opposite of a stock split. Instead of multiplying shares to lower the per-share price, shares are divided to reduce the number of outstanding shares and boost the share price.
This is often done to prevent a stock from being delisted on a major exchange (major exchanges enforce a minimum share price to protect investors) or to increase the credibility of the stock.
Institutional and retail investors alike often scoff at “penny stocks,” and a reverse split that boosts share price can be a way to get on investors’ radar and encourage investment.