A stock split is a maneuver where companies replace each share with a certain number of newly issued shares so that each shareholder still has the same stake in the company. For instance, in a two-for-one split, each investor receives two new shares for each old shares. It's usually done to lower the price of the stock after gains to make it more approachable to buy for investors. In some cases, a company may do a reverse stock split, replacing each set of a certain number of shares with a smaller number of new shares, worth more.
A stock split and reverse stock split are two tools used by corporations to increase or decrease the number of ownership shares available to the public. Whichever action occurs, the current market capitalization of the company is not affected.
Defining Stock Splits
Companies announce stock splits as a ratio of two numbers. Thus, in a 2 for 1 stock split, sometimes written as a 2:1 split, shareholders get two new shares for every share they hold. This doubles the float and halves the stock price. The idea behind a share split is to get the price down to where small investors find the shares a bit more affordable. Generally, public companies always want to increase the number of shareholders to get a larger percentage of the public supporting the company's success.
Understanding a Reverse Split
A reverse stock split turns the ordinary stock split on its head. In a reverse-split ratio, the second number is larger than the first. In a 1:50 split, shareholders get one share for every 50 old shares. The ordinary stock split and the reverse split take effect automatically and are calculated for shareholders by their account managers. You'll normally receive notification from your brokerage about the split and will see the change in number of shares you own reflected in your online brokerage account or printed account statements.
After a 1:50 split, for example, a stockholder with 500 shares, will open his account screen to find that he now holds 10. Companies do not require shareholder approval for stock splits, nor is this maneuver under any kind of regulatory control by the federal government.
Important Price Considerations
The stock market works through a complex network of computer systems that remain under human management. These systems allow stock prices to be manually adjusted when companies announce stock splits. That's why when a 2:1 split comes along, the stock price falls by half. When a 1:50 split happens, the market systems adjust the stock price upward by a factor of 50.
Remember that since the price of shares changes at the time of the split or reverse split, the total value of your holdings isn't affected by a split or reverse split. One advantage to a traditional split is that you can now effectively trade stock in smaller increments. For instance, if a share was worth $100 prior to a 2:1 split, you would only have been able to buy or sell $100 worth of stock at a time. Following the split, you can buy and sell in $50 increments.
While the company valuation remains the same, the number of outstanding shares is reduced. Shareholders who end up with less than a share after a reverse split may be automatically cashed out of their holding by their broker.
Purpose of Splits
The purpose of a reverse split is simply to get the stock price up. For various reasons, companies don't want to see their stock price fall below important benchmarks. Large institutional investors, such as mutual funds, often have restrictions against buying low-priced stocks. The exchanges also have standards.
If a company's average closing price stays below $1 for more than 30 trading days in a row, the New York Stock Exchange sets a six-month "cure period," after which it will de-list the stock if it doesn't get back above a buck. Although the aggregate value of the shares remains the same, a higher stock price will avoid the stigma of the "penny stock" and make an extremely inexpensive stock look a little more appealing to the general investor.
Founder/president of the innovative reference publisher The Archive LLC, Tom Streissguth has been a self-employed business owner, independent bookseller and freelance author in the school/library market. Holding a bachelor's degree from Yale, Streissguth has published more than 100 works of history, biography, current affairs and geography for young readers.