Explained: What Happens When a Stock Splits?
Are stock splits good or bad? How do they affect your portfolio? Learn about the ins and outs, advantages, and risks of stock splits.
When companies are concerned that their share price is too low or too high, they can choose to perform a reverse stock split or stock split, respectively. This process allows the company to either boost its share prices to preserve its listing on stock exchanges or lower its share prices to attract new investors.
Either way, it’s important to understand what happens when a stock splits. Is it good or bad for investors? Let’s find out.
What Are Stock Splits?
Stock splits are how a company can increase its number of outstanding shares and lower the share price. Many use this tactic to attract smaller investors, particularly when stock prices are at all-time highs.
While the company’s value and your investment’s value don’t change during a stock split; understanding how this happens is crucial for investors. When looking at stock splits, you’ll see things like “2-for-1,” but what happens when a stock splits in different ways?
If a company announces a stock split that’s 2-for-1, the original number of shares will double. Shareholders still hold the same percentage of stock, but there are more shares overall.
This same principle applies to any stock split ratio. There are also reverse stock splits, which go in the opposite direction — we’ll discuss these more later.
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What Happens When a Stock Splits?
Does a stock split make investors rich? Well, no. The market capitalization of a company (outstanding shares x the price per share) doesn’t change when a stock split happens — when the number of shares increases, the price per share decreases by a proportional amount.
So, a stock worth $500 would trade for $250 after a 2-for-1 stock split. Investors will own more shares, but each one is worth less than before. The investment’s value doesn’t change.
However, most investors welcome stock splits; it signals that a company wants to attract more investors by making its shares more affordable. That will likely result in stock prices rising in the future.
Why Do Stock Splits Happen?
Once a company’s stock price increases enough to make it difficult for more investors to purchase, or the prices rise significantly beyond similar businesses in its sector, the board of directors may start a stock split.
Stock splits are a way to make shares seem more affordable without affecting the company’s underlying value — it can also increase the liquidity of those stocks.
However, when a stock splits, share prices can actually increase, even though they will decrease immediately after the split. Why does this happen? Smaller investors see that it’s more affordable and buy up shares, boosting demand for the stocks. This can lead some investors to believe the stock’s demand will continue growing, taking the price even higher.
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What About Reverse Stock Splits?
On the other hand, we have reverse stock splits, which happen when a company with low share prices wants to increase them. It’s a way for companies to gain popularity in the market or avoid getting delisted on the exchange.
For example, if you owned 20 shares of stock, and they announced a 2-for-1 reverse stock split, you would end up owning ten shares instead. However, the total value of your shares would be the same. So, if it was worth $5 per share before the split, they would now be worth $10 each.
How Do Stock Splits Affect Investors?
If you’ve already bought shares of stock, you likely won’t notice any changes in the value of your investment when a stock split happens. There are not necessarily any changes for those who already own shares. There are no changes in ownership or operations, and you might have double the shares as before, but they are worth half the price, balancing out your investment.
However, for those who aren’t current shareholders, stock splits can motivate them to invest. For example, smaller investors may not have been able to afford a single share of an expensive stock, but after a split, it’s more achievable.
The ability for more investors to buy a certain stock can increase its price, which can, in turn, increase the company’s value — even if it’s temporary. When more people can access a stock, demand typically rises, which can also increase the price. So, if you own more shares, a stock split can be beneficial in the long run.
Pros and Cons of Stock Splits
Stock splits aren’t inherently good or bad; they have benefits and risks for companies and shareholders.
Advantages of Stock Splits
The primary advantage of stock splits for a company is making it easier for more investors to buy shares. However, higher numbers of outstanding shares also increase stock liquidity, facilitating more trades and narrowing the bid-ask spread. Stock splits make trading easier for buyers and sellers.
In theory, a stock split doesn’t affect stock prices but results in more investor interest, which can increase prices. This effect typically wanes over time but shows that a company is looking to grow, indicating confidence in the company’s future profitability.
It’s not uncommon for top companies to have their share values return to levels before a stock split, leading to another split. For example, Walmart split its stock multiple times between 1970 and 1999 — if you bought 100 shares at its IPO, you would own almost 205,000 after those 29 years.
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Disadvantages of Stock Splits
Every facet of stock splits doesn’t benefit companies or investors. Splitting stock is expensive, requires compliance with regulatory laws, and needs comprehensive legal oversight.
While stock splits aren’t worthless, they also don’t impact the company’s fundamental position or create additional value.
On the other hand, some companies believe that stock splits attract the “wrong” kind of investors. For example, if a high-value company splits its stock so that more traders can invest, it makes the shares seem less exclusive to current investors.
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