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Understanding Stock Splits and Their Impact

A stock split is when a company divides its existing shares into multiple new shares to boost liquidity without changing the total dollar value of shares. Common split ratios are 2-for-1 or 3-for-1. Companies split stock to lower the price per share and increase liquidity for investors, making the stock more accessible. During a split, the number of shares outstanding increases while the price per share decreases proportionately so the total market value remains the same.

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80 views4 pages

Understanding Stock Splits and Their Impact

A stock split is when a company divides its existing shares into multiple new shares to boost liquidity without changing the total dollar value of shares. Common split ratios are 2-for-1 or 3-for-1. Companies split stock to lower the price per share and increase liquidity for investors, making the stock more accessible. During a split, the number of shares outstanding increases while the price per share decreases proportionately so the total market value remains the same.

Uploaded by

Niño Rey Lopez
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Stock Split

What Is a Stock Split?


A stock split is when a company divides the existing shares of its stock into
multiple new shares to boost the stock's liquidity. Although the number of shares
outstanding increases by a specific multiple, the total dollar value of the shares
remains the same compared to pre-split amounts, because the split does not add
any real value.

The most common split ratios are 2-for-1 or 3-for-1 (sometimes denoted as 2:1 or
3:1), which means that the stockholder will have two or three shares after the
split takes place, respectively, for every share held prior to the split.

KEY TAKEAWAYS

 A stock split is when a company divides the existing shares of its stock into
multiple new shares to boost the stock's liquidity.
 Although the number of shares outstanding increases by a specific
multiple, the total dollar value of the shares remains the same compared to
pre-split amounts, because the split does not add any real value.
 The most common split ratios are 2-for-1 or 3-for-1, which means that the
stockholder will have two or three shares, respectively, for every share
held earlier.
 Reverse stock splits are effectively the opposite transaction, where a
company divides, instead of multiplies, the number of shares that
stockholders own, raising the market price accordingly.
How a Stock Split Works
A stock split is a corporate action in which a company divides its existing shares
into multiple shares. Basically, companies choose to split their shares so they
can lower the trading price of their stock to a range deemed comfortable by most
investors and increase the liquidity of the shares.

Most investors are more comfortable purchasing, say, 100 shares of $10 stock
as opposed to 10 shares of $100 stock. Thus, when a company's share price has
risen substantially, many public firms will end up declaring a stock split at some
point to reduce the price to a more popular trading price. Although the number of
shares outstanding increases during a stock split, the total dollar value of the
shares remains the same compared to pre-split amounts, because the split does
not add any real value.

When a stock split is implemented, the price of shares adjusts automatically in


the markets. A company's board of directors makes the decision to split the stock
into any number of ways. For example, a stock split may be 2-for-1, 3-for-1, 5-for-
1, 10-for-1, 100-for-1, etc. A 3-for-1 stock split means that for every one share
held by an investor, there will now be three. In other words, the number
of outstanding shares in the market will triple.

On the other hand, the price per share after the 3-for-1 stock split will be reduced
by dividing the price by three. This way, the company's overall value, measured
by market capitalization, would remain the same.

Market capitalization is calculated by multiplying the total number of shares


outstanding by the price per share. For example, assume that XYZ Corp. has 20
million shares outstanding and the shares are trading at $100. Its market cap will
be 20 million shares x $100 = $2 billion. Let's say the company’s board of
directors decides to split the stock 2-for-1. Right after the split takes effect, the
number of shares outstanding would double to 40 million, while the share price
would be halved to $50, leaving the market cap unchanged at 40 million shares x
$50 = $2 billion.

 
In the UK, a stock split is referred to as a scrip issue, bonus issue, capitalization
issue, or free issue.

Reasons for a Stock Split


Why do companies go through the hassle and expense of a stock split? For a
couple of very good reasons. First, a split is usually undertaken when the stock
price is quite high, making it expensive for investors to acquire a standard board
lot of 100 shares.

Second, the higher number of shares outstanding can result in


greater liquidity for the stock, which facilitates trading and may narrow the bid-
ask spread. Increasing the liquidity of a stock makes trading in the stock easier
for buyers and sellers. Liquidity provides a high degree of flexibility in which
investors can buy and sell shares in the company without making too great an
impact on the share price. Added liquidity can reduce trading slippage for
companies that engage in share buyback programs. For some companies, this
can mean significant savings in share prices.

While a split, in theory, should have no effect on a stock's price, it often results in
renewed investor interest, which can have a positive impact on the stock price.
While this effect can be temporary, the fact remains that stock splits by blue-
chip companies are a great way for the average investor to accumulate an
increasing number of shares in these companies.
Many of the best companies routinely exceed the price level at which they had
previously split their stock, causing them to undergo a stock split yet again.
Walmart, for instance, has split its shares as many as 11 times on a 2-for-1 basis
from the time it went public in October 1970 to March 1999. An investor who had
100 shares at Walmart’s initial public offering (IPO) would have seen that little
stake grow to 204,800 shares over the next 30 years.1

Example of a Stock Split


In August 2020, Apple (AAPL) split its shares 4-for-1 to make it more accessible
to a larger number of investors.2 Right before the split, each share was trading at
around $540. After the split, the price per share at the market open was $135
(approximately $540 ÷ 4). Existing shareholders were also given four additional
shares for each share owned, so an investor who owned 1,000 shares of AAPL
pre-split would have 5,000 shares post-split. Apple's outstanding shares
increased from 3.4 to approximately 13.6 billion shares, however, the market cap
remained largely unchanged at $2 trillion.

Stock Split vs. Reverse Stock Splits


A traditional stock split is also known as a forward stock split. A reverse stock
split is the opposite of a forward stock split. A company that issues a reverse
stock split decreases the number of its outstanding shares and increases the
share price. Like a forward stock split, the market value of the company after a
reverse stock split would remain the same. A company that takes this corporate
action might do so if its share price had decreased to a level at which it runs the
risk of being delisted from an exchange for not meeting the minimum price
required to be listed. A company might also reverse split its stock to make it more
appealing to investors who may perceive it as more valuable if it had a higher
stock price.

A reverse/forward stock split is a special stock split strategy used by companies


to eliminate shareholders that hold fewer than a certain number of shares of that
company's stock. A reverse/forward stock split uses a reverse stock split followed
by a forward stock split. The reverse split reduces the overall number of shares a
shareholder owns, causing some shareholders who hold less than the minimum
required by the split to be cashed out. The forward stock split increases the
overall number of shares a shareholder owns.

Frequently Asked Questions


What happens if I own shares that undergo a stock split?
When a stock splits, it credits shareholders of record with additional shares,
which are reduced in price in a comparable manner. For instance, in a typical 2:1
stock split, if you owned 100 shares that were trading at $50 just before the split,
you would then own 200 shares at $25 each. Your broker would handle this
automatically, so there is nothing you need to do.

Will a stock split impact my taxes?


No. The receipt of the additional shares will not result in taxable income under
existing U.S. law. The tax basis of each share owned after the stock split will be
half of what it was before the split. 

Are stock splits good or bad?


Stock splits are generally done when the stock price of a company has risen so
high that it might become an impediment to new investors. Therefore, a split is
often the result of growth or the prospects of future growth, and is a positive
signal. Moreover, the price of a stock that has just split may see an uptick as new
investors seek the relatively better-priced shares.

Does the stock split make the company more or less valuable?
No, splits are neutral actions. The split increases the number of shares
outstanding, but its overall value does not change. Therefore the price of the
shares will adjust downward to reflect the company's actual market capitalization.
If a company pays dividends, new dividends will be adjusted in kind. Splits are
also non-dilutive, meaning that shareholders will retain the same voting rights
they had prior to the split.

Can a stock split be anything other than 2-for-1?


While a 2:1 stock split is the most common, any other ratio may be carried out so
long as it is approved by the company's shareholders and board of directors.
These may include, for instance, 3:1, 10:1, 3:2, etc. In the last case, if you owned
100 shares you would receive 50 additional shares post-split.

Common questions

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Stock splits do not result in any immediate tax liabilities for shareholders, as they simply receive additional shares without any intrinsic increase in value . The tax basis of each share post-split is adjusted to reflect half of its pre-split value, aligning with the doubled share quantity . Despite being a neutral event in terms of actual value, stock splits can affect perceptions, as increased affordability may lead to heightened investor interest and potentially boost the stock price, suggesting growth or positive future prospects . However, this effect is more psychological and market-driven rather than based on the concept of accrued value.

While a stock split does not change the intrinsic value of a company, it often results in increased investor interest due to shares being perceived as more affordable. This perception can drive demand and positively impact the share price, as observed when companies like Apple implemented splits that led to higher trading volumes and increased share purchasing . Renewed interest can thus temporarily elevate stock prices, reflecting a broader base of potential shareholders and causing a psychological effect even if the company’s market capitalization remains unchanged .

Companies typically initiate a stock split to lower the trading price of their stock to make it more accessible to a broader range of investors and to increase the stock's liquidity, thereby facilitating easier trading . Although the stock split does not add real value to the company, it can positively impact investor perception by making shares seem more affordable, potentially stimulating increased interest and activity among investors. This perceived affordability can contribute to an uptick in the share price due to renewed demand, despite the actual value remaining unchanged .

Companies choose specific stock split ratios based on strategic objectives such as aligning share prices with investor expectations or adjusting to varying market conditions. For example, a 3-for-1 or 10-for-1 split may be driven by a company's desire to make its shares more psychologically accessible to smaller investors or to integrate a more optimal trading price in response to excessive price increases . These choices can reflect a company’s analysis of investor behavior, potential liquidity outcomes, and how best to maintain or enhance market capitalization without affecting inherent value . Larger split ratios might be used to drastically lower the price and broaden accessibility when stock prices have excessively appreciated.

The benefits of a reverse stock split include potential prevention of delisting from stock exchanges by increasing the share price and maintaining compliance with listing standards, as well as possibly attracting a different investor profile who perceives higher priced shares as more valuable . However, drawbacks may include a negative market perception, as reverse splits can sometimes be viewed as a method to artificially inflate share prices due to underlying business challenges or as a signal of distress, potentially causing adverse market reactions . Companies must weigh these factors carefully when considering this corporate action.

Stock splits do not inherently alter a company's dividend policy or shareholder voting rights. Although the number of shares increases, dividends are generally adjusted so that the value shareholders receive remains consistent on a per share basis . Voting rights remain proportional as well; shareholders retain equivalent voting power relative to their total shares held pre-split. The split is non-dilutive regarding both dividends and voting rights, maintaining shareholder influence even as the number of shares increases . Thus, the impact of a stock split is negligible on these aspects, focusing primarily on liquidity and share accessibility.

Stock splits tend to significantly impact smaller investors by making shares more affordable and increasing accessibility, thus encouraging more participation from this group due to lowered economic barriers . Conversely, larger institutional investors focus on market behavior over nominal share price changes, using splits as indicators of company health or popularity rather than direct investment motivations. The added liquidity from splits can benefit all investors by narrowing bid-ask spreads, though the perception-driven price changes may be more pronounced among smaller investors who are sensitive to share price changes .

Consider a company with 20 million shares outstanding, trading at $100 each, resulting in a market capitalization of $2 billion . If the company decides on a 2-for-1 stock split, the number of shares doubles to 40 million, and the price per share is halved to $50. This leaves the overall market capitalization unchanged at $2 billion (40 million shares x $50 per share). The multiplication of shares is offset by the decrease in individual share price, ensuring the company's market value remains constant.

Stock splits are often a reflection of a company's robust growth prospects or the anticipation thereof, as they typically occur when the share price has risen significantly, suggesting underlying business success or optimistic market expectations . Historically, repeated stock splits by prominent companies like Walmart have demonstrated that splits can be a positive market signal, as these companies continue to grow, necessitating multiple splits to maintain attractive share prices for investors . The cycle of price elevation and subsequent splitting can indicate ongoing performance strength and investor confidence.

A reverse stock split reduces the number of outstanding shares while increasing the share price, effectively the opposite of a regular stock split, which increases shares and reduces the share price . Companies may opt for a reverse stock split to avoid delisting from stock exchanges due to low share prices or to make their stock appear more valuable to investors. By reducing the overall number of shares, the company may target a more favorable stock price that aligns with investor perceptions of value, maintaining listing status and potentially broadening investor appeal .

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