I . What Is a Stock Split?

A stock split happens when a company increases the number of its shares to boost the stock's liquidity.

Although the number of shares outstanding increases by a specific multiple, the total dollar value of all shares outstanding remains the same because a split does not fundamentally change the company's value.

KEY TAKEAWAYS

A stock split is when a company increases the number of its outstanding shares to boost the stock's liquidity.

Although the number of shares outstanding increases, there is no change to the company's total market capitalization as the price of each share will split as well.

The most common split ratios are 2-for-1 or 3-for-1, which means every single share before the split will turn into multiple shares after the split.

A company elects to perform a stock split to intentionally lower the price of a single share, making the company's stock more affordable without losing value.

Reverse stock splits are the opposite transaction, in which a company lowers, instead of increasing, the number of shares outstanding, raising the share price accordingly.

II . How a Stock Split Works

A stock split is a corporate action in which a company issues additional shares to shareholders, increasing the total by the specified ratio based on the shares they held previously. Companies often choose to split their stock to lower its trading price to a more comfortable range for most investors and to increase the liquidity of trading in its shares.

Most investors are more comfortable purchasing, say, 100 shares of a $10 stock as opposed to 1 share of a $1,000 stock. So when the share price has risen substantially, many public companies end up declaring a stock split to reduce it. Although the number of shares outstanding increases in a stock split, the total dollar value of the shares remains the same compared with pre-split amounts, because the split does not make the company more valuable.

A company's board of directors can choose to split the stock by any ratio. 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 old share price by 3. That's because a stock split does not alter the company's value as measured by market capitalization.

Special Considerations

Market capitalization is calculated by multiplying the total number of shares outstanding by the price per share. For example, assume 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. Although both the number of shares outstanding and the market price have changed, the company's market cap remains unchanged at (40 million shares x $50) $2 billion.

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

III. Advantages & Disadvantages of a Stock Split

Advantages

Why do companies go through the hassle and expense of a stock split?

a.) First, a company often decides on a split when the stock price is quite high, making it expensive for investors to acquire a standard board lot of 100 shares.

b.) 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. This can help companies repurchase their shares at a lower cost since their orders will have less of an impact on a more liquid security.

c.) 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 effect on the stock price. While this effect may wane over time, stock splits by blue-chip companies are a bullish signal for investors. A stock split may be viewed by some as a company wanting a bigger future runway for growth; for this reason, a stock split generally indicates executive-level confidence in the prospect of a company.

Disadvantages

a.) Not all facets of a stock split benefit a company. The process of a stock split is expensive, requires legal oversight, and must be performed in accordance with regulatory laws. The company wanting to split their stock must pay a great deal to have no movement in its over market capitalization value.

b.) Some opponents of stock splits view the action as having the potential to attract the wrong crowd of investors. Consider Berkshire Hathaway's Class A shares trading for hundreds of thousands of dollars. Had Warren Buffet split the stock, many traders in the general public would be able to afford his company's shares. Instead, to maintain equity ownership as exclusive, a company may want to intentionally not split its shares.

c.) Last, there are implications for intentionally reducing the company's share price. Public exchanges such as the NASDAQ require stock to trade at or above $1. Should a share price drop below $1 for thirty consecutive days, the company will be issued a compliance warning and will have 180 days to regain compliance. Should the company's stock price still not meet minimum pricing requirements, the company risks being delisted.

IV. Example of a Stock Split

In August 2020, Apple (AAPL) split its shares 4-for-1.

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).

An investor who owned 1,000 shares of the stock pre-split would have owned 4,000 shares post-split. Apple's outstanding shares increased from 3.4 billion to approximately 13.6 billion, while the market capitalization remained largely unchanged at $2 trillion.

A company may choose to split its stock as many times as it would like. For instance, Apple also split its stock 7-for-1 in 2014, 2-for 1 in 2005, 2-for-1 in 2000, and 2-for-1 in 1987.

To convert a quantity of pre-split shares to post-split shares across multiple splits, multiple the ratio value of each split together. For example, a single pre-split share in 1987 would have eventually been split into 224 shares after the 2020 split. This is determined by multiplying 4, 7, 2, 2, and 2.

V . Stock Splits 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 carrying out a reverse stock split decreases the number of its outstanding shares and increases the share price proportionately. As with a forward stock split, the market value of the company after a reverse stock split remains 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 for a listing. Certain mutual funds may not invest in stocks priced below a preset minimum per share. A company might also opt for a reverse split to make its stock more appealing to investors who may perceive higher-priced shares as more valuable.

A reverse/forward stock split is a special stock split strategy used by companies to eliminate shareholders holding less than a certain number of shares. A reverse/forward stock split consists of 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 then increases the number of shares owned by the remaining shareholders.

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