A stock split is when a company divides their existing shares into additional shares. A company may decide to do this to boost their liquidity. It usually occurs when the price of the company’s shares increases too high.
By splitting their stock, they can increase the number of shares available for investors and therefore, decrease the price of the individual stock.
How Does a Stock Split Work?
Stock splits occur when a company divides the number of shares available into additional shares. A company can decide to split their stock however they choose. Most commonly, you will see 2-for-1 (2:1) or 3-for-1 (3:1).
This decision is usually made by the board of directors to make their stock more appealing to investors. The overall price of your investment will not change. However, the number of shares that you own will increase.
What Is an Example of a Stock Split?
Let’s look at an example of a stock split. Let’s say company XYZ has 1,000 shares of stock available when they decide to split their stock 2-for-1. This means that each share will now split into two and they will have 2,000 shares available.
Splitting stock will also cause the price of a share to decrease. If the shares in this example were originally priced at $40/share, they would now be priced at $20/share after the 2-for-1 split.
If you owned 100 shares at $40/share of XYZ initially and they decided to split their stock 2-for-1, you would now own 200 shares at $20/share. The overall price of your investment is still $400 but now you own double the amount of shares.
What Happens When a Stock Splits?
When a stock splits, the number of shares increases by the ratio of the split. You will also see the price of each share decrease by the ratio. If a stock splits by a 2-for-1 ratio, the number of shares will double and the price per share will be halved.
The same principle applies if the stock splits by 3-for-1, 3-for-2, or whatever the board of directors decides.
How To Calculate a Stock Split
The easiest way to calculate a stock split is to take the previous price of a share and divide it by the stock split ratio. If a company decides to do a 2:1 stock split and their price per share was at $100/share, their new price per share will be $50/share ($100/2 = $50).
If they decided to split their stock 3:2, the new price per share would be [$100/(3/2)]= $66.67 per share.
What Are Stock Splits Ratios?
A stock split ratio is the ratio in which a company has decided to split their stock. As mentioned above, a company can decide to split their stock however they choose. That being said, there are a few common ratios that you are more likely to see when a company decides to split their stock.
The most common ratios you will see are 2-for-1 or 3-for-1. These can also be represented as 2:1 or 3:1, respectively.
Types of Stock Splits
There are two main types of stock splits: forward stock split or reverse stock split. Each type can signal a different meaning within a company.
It is important to understand the difference between forward and reverse stock splitting when looking to invest in the shares of a company.
What Is a Forward Stock Split?
A forward stock split, more traditionally known as a stock split, is when a board of directors decides they need to increase their number of shares and decrease the price per share of their stock. This usually occurs when the price per share is increasing too high.
By splitting their stock, they are making their shares more appealing to investors. It can also signal that the company is profiting and doing well.
What Is a Reverse Stock Split?
A reverse stock split occurs by decreasing the number of shares available to invest in. This usually indicates that a company is not doing as well as they hoped and they need to increase the price per share of their stock in order to keep it listed within the market. When a company decides to reverse stock split, the number of shares that you own will merge by the ratio that they decided to split at.
Let’s say you had 100 shares of stock in company XYZ at $10/share. Company XYZ then decides to reverse split their stock 1-for-5. This means that you will now have 100/5, or 20 shares. If the price per share was $10/share, it will now be $10 x 5, or $50/share.
So instead of 100 shares at $10/share, you will now have 20 shares at $50/share. As with a forward split, your overall investment remains the same; however, the amount of shares and the price per share will change.
How Are Investors Affected By a Split?
Essentially, a stock split does not change your overall investment amount. However, it may increase or decrease your number of shares, depending on how the company has decided to split their stock. It can also be indicative of how well the company is doing.
If their price per share is increasing too much and they decide to forward split their stock, it could mean they are doing well. Inversely, if they decide to reverse split their stock, it could signal that they are in trouble.
How Stock Splits Affect You
If you own shares of stock within a company and they decide to split their stock, it is important to understand what kind of stock split they will undergo. Always keep in mind that your overall investment will not change.
However, you may see an increase or decrease in the number of shares you now own. You may also notice the price per share has changed.
Consulting with a financial advisor can help guide you through your investments and any stock splitting that may have occurred. While it may be a fairly simple concept to understand, it is always beneficial to have a financial advisor at your disposal to discuss your investment options.