There are myriad terms that define the investment world. Especially for someone who is a novice in this pursuit, they can often be difficult and confusing to navigate. One such term is “stock split.” You may have heard this term in the news or via online stock market channels and wondered what it means. What is a split, exactly, and is it a good thing?
In short, a stock split occurs when a publicly-traded company’s leadership determines it is time to increase the number of shares issued to current shareholders. This, in turn, ups the number of outstanding shares associated with the company. For example, one of the most common types of stock split is a 2-for-1 split, wherein an additional share is given to a recipient who currently only holds one share in the company. As a result, the number of currently outstanding shares available for that given company is doubled as well.
What Does a Stock Split Affect?
One of the major elements affected by a stock split is the price of the stock itself. This goes back to the simple logic of supply and demand. When shares are more readily available and easy to come by, as happens after a split, there is less competition amid prospective shareholders. This causes the price of the stock to decrease in most cases.
In the aforementioned 2-for-1 split, for instance, the share price would be essentially cut in half. This balanced change in ratio means that although there are fluctuations in price, the capitalization is able to stay constant.
What Catalyzes a Stock Split?
Often, company leaders will meet and determine that their share prices have reached an unmanageable level. There is usually one of two reasons behind this. Either the prices have become too high in general or they are not in keeping with the share prices of other similar firms in the same industry. As this can discourage investors from taking a chance at a small company, business leaders will take steps to incrementally lower the share price to make it more attractive and affordable. While this is a tactic that startups and small businesses employ to improve their market performance, it is important to note that even major corporations have a history of stock splitting. Consider, for instance, the IBM split history. The first split occurred in 1964 on a 5-4 basis, catalyzing a pattern that continued steadily until the late 1990s.
Somewhat ironically, though there is a period of decline in share prices immediately following a stock split, it is often quickly followed by an uptick in price. Why? Interested investors who have been following the stock and noticed the drop in price quickly clamor to buy it up, thereby ramping up demand and in effect, causing prices to rise alongside. Prices also increase because the act of a company splitting its stock can signal a high share price, which tells investors that the company is growing and performing well. As such, interest is piqued and demand is raised.
What about a Reverse Stock Split?
While stock splits are one of the most common actions a publicly traded company can take, there are also reverse stock splits, which sound as their name implies. In these instances, a company divides and lowers the number of shares it currently has outstanding. This is usually done when a company’s share prices have dipped so low they are in danger of becoming delisted on the stock market.
A reverse stock split can help get a fledgling company back on its feet, improve its respectability and boost its bottom line. Consider, for example, a company that engages in a 1-for-5 split of 20 million shares. If one share originally sold at $.50 each, it would change to $2.50 (.50 x 5), and the number of shares would drop to four million (20/5). The idea behind making this shift is that supply will decrease, amping up demand and profit will soon follow.
Navigating Stock Splits as an Investor
Moving forward, savvy investors will be those who monitor the market for these changes, research the facts behind them and consider the performance of the company itself before making any decisions. While neither a stock split nor a reverse stock split are concrete signs that a company is a surefire bet or a definite “no,” they are signs that activity is taking place within the leadership department and decisions are being made. Whether or not those decisions will help or hurt investors will be determined down the road.