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What to know about stock splits

Investment and Asset Management

From time to time, public companies announce stock splits or reverse stock splits. If this happens to a stock you own, it’s important to understand what these terms mean and, perhaps more important, what they don’t mean.

Pieces of the pie

A stock split occurs when a public company divides its existing shares, resulting in a greater number of them. Typically, this is accomplished by exchanging each existing share for multiple shares of the same company’s stock. This process doesn’t change the company’s overall market capitalization, nor does it change the company’s value or an individual investor’s holdings. Rather, it increases the number of outstanding shares while proportionately reducing the price per share.

Think of a company’s market cap as a pie — cutting the pie into smaller pieces doesn’t change the total amount of pie. Suppose, for example, a company has 5 million shares outstanding, currently worth $10 per share, for a total market cap of $50 million. If the company facilitates a two-for-one (2:1) stock split, it ends up with 10 million shares worth $5 per share, but its market cap remains $50 million. Similarly, an individual investor who owns 500 $10 shares of the company before the split will own 1,000 $5 shares after the split.

Reasoning behind it

Usually, when a company announces a stock split, it’s because management believes the stock price has gotten too high relative to its peers and that a lower price will boost liquidity. Let’s say that two companies are otherwise comparable, but one’s stock is trading at $500 per share and the other’s is trading at $100 per share. Smaller investors may be more likely to invest in the company with the lower stock price. A stock split may also help draw attention to the company’s strong performance and signal management’s confidence in its future prospects.

Yet contrary to what some investors may believe, a stock split doesn’t increase the value of their holdings overnight. As already noted, increasing the number of shares while proportionately reducing the price has no direct impact on value. However, it’s possible that a stock split will increase demand by highlighting the stock’s recent performance and making it visible to a new pool of investors. There’s no guarantee that a stock’s price will rise, and in fact, it might fall and you could lose the money you’ve invested. But stock splits can result in higher short-term prices.

Opposite direction

A reverse stock split is the opposite of a regular stock split. A company combines its existing shares into a smaller number of higher-priced shares. So, for example, if a company with 10 million shares worth $2 per share undergoes a one-for-five (1:5) reverse stock split, it will end up with 2 million $10 shares.

Like a regular split, a reverse split doesn’t directly affect the value of shares. But it may be a red flag that the company is struggling. That’s because public companies often conduct reverse stock splits when the price has dropped below a stock exchange’s minimum threshold and is at risk of being delisted. However, a reverse split isn’t always a bad sign. A company may, for instance, believe that increasing its share price will enhance its visibility among institutional investors.

Review the fundamentals

At base, stock splits and reverse stock splits are neither positive nor negative. But the reasons behind a company’s decision to split stock may be significant. If a company whose stock you own announces such a transaction, revisit the underlying fundamentals of the business and evaluate its future prospects. Your financial advisor can help you determine whether such securities belong in your investment portfolio given your situation and goals.

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