Updated Feb 20, 2022
What is a Stock Split?
What is a Stock Split?
Introduction
As an investor, splitting shares may not be the topmost priority. However, when it comes to stocks, the benefits are many. As is evident from the name, a stock split is a process by which companies take into account their existing shares and divide them into smaller, more affordable shares for their stockholders. Although this may affect the price of the shares, it will not affect the company’s overall value or market capitalisation.
When a company decides to split its stock, they first determine the split ratio, which can be done in multiple permutations. The most common ratios are 2-for-1, 3-for-1, and 3-for-2. For example, if a company decides to go for a 2-for-1 split and has 20 million outstanding shares, the number of shares will increase to 40 million, and shareholders will get an additional stock for everyone they have already bought. However, this means that the price of these stocks they hold will go down by 50%.
What Are the Reasons for a Stock Split?
A stock split occurs for many reasons. Nonetheless, the prime intention behind a stock split is to improve the stock’s liquidity and make it more affordable to investors. Companies tend to split their stocks because the price of the share is too high and beyond the affordable benchmark of other competitors. Other reasons for stock splits are:
- Company Growth
When a stock splits, this generally indicates that a company is growing. However, this is generally followed by unreasonable returns for investors who might get substantially more or less than what they invested.
2. Better Trading
Every stock market has a variety of shares for investors to choose from. However, when the price comes down, it makes these shares easier to trade. Stock splits allow the shares to get back to normal trading prices, which makes it better for investors.
3. Competitive Advantage
To gain a competitive advantage, companies can split their stocks to determine whether they’re at par with the market. This helps them understand whether they are undervaluing themselves. This way, companies can also attract investors’ attention in the larger market.
What Benefits Does a Stock Split Have?
When a stock splits, it makes it easier for investors to consider buying the company’s shares at a lower price. However, investors need to be aware that this could also result in lower returns on investment. This does not mean that they will lose money, but it is a much safer option to buy shares at lower prices than wait for the price to become higher and sell them, given the volatility of the stock market.
Another advantage of a stock split for investors is that they can more or less be sure that the company is growing in reputation and stock prices. This means that in the future, if they invest in a company that has gone through a stock split will continue to grow, and the share price is likely to increase.
What is a Reverse Stock Split?
A reverse stock split is the opposite of a stock split, where companies decide to halve their shares instead of double them. This generally happens when there are fewer outstanding shares and the company is already doing well in the market. A reverse stock split works exactly like a stock split, the only difference being the increase in share price and earnings per share.
A reverse stock split is very rare because shares often underperform in the market after a reverse stock split. In the case of a reverse stock split, the share price is extremely low, and companies only consider this tactic if they cannot find alternate ways of trading their shares to investors. Some stock exchanges require a minimum listing for share prices, without which companies face the risk of being delisted from the market.
Conclusion
No matter how companies choose to trade, it is important to keep in mind the shareholders when setting the price of the stock. Whether this means splitting the stock or reverse splitting the stock, companies need to ensure that their stock prices are at par with their competition in the market. In addition to that, they also need to ensure that they have enough outstanding stocks to trade because without those, they cannot split their stocks.
