A stock split is a process that exchanges each share of a company's stock for a different number of new shares. Companies usually use stock splits to keep the share price in a range that's attractive to investors. If you're comparing prices before and after a stock split, you need to adjust for the split to understand if the company is getting more or less valuable.
Stock splits replace shares in a company with a different number of new shares that represent the same portion of the company's total outstanding stock. Generally, the result of a stock split is: traditional stock splits give out more new shares for each old share and lower the price per share, and reverse stock splits do the opposite and raise the price per share.
Stock Prices and Investing Decisions
Ordinarily, each share of stock in a company represents a fractional ownership interest in that company. Stocks in publicly traded companies can be bought and sold on open exchanges like the New York Stock Exchange and the Nasdaq, and prices fluctuate based on investor perceptions of how well the company is doing, the dividends that are paid out to investors and other factors.
When stock prices in a company go too high, they may price out certain investors who are intimidated by the high price. Conversely, if they go too low, some investors may see the stock as less attractive.
Understanding Stock Splits
To keep prices within a certain range, companies can use what are called stock splits, which issue new stock to replace existing stock. For example, in a 2:1 stock split, each old share is replaced with two new shares. After you split it, the share price will normally end up going down, since each share now represents less of the company than it did before, but each shareholder will still have the same stake in the company.
Conversely, a reverse stock split replaces each share with fewer new shares and usually leads to a higher share price. For example, a 1:3 stock split replaces every three shares with a single share. It's sometimes possible to end up with partial shares of a company's stock, but these fractional shares are often simply converted to cash for convenience's sake. Reverse stock splits can be useful for companies to comply with rules of exchanges that mandate a minimum share price for each traded company.
Stock splits are different from share buybacks, where companies use their own money to buy shares from investors, and from situations in mergers where holders of pre-merger stock might end up with a different number of shares in the stock of the combined company.
Reasoning Around Stock Splits
A stock split is publicly announced by the company, and financial news and information sites will usually automatically adjust charts and performance indicators to compensate for the split. After all, it's not remarkable if a company's share price suddenly falls by 50 percent when a share is effectively worth 50 percent less, so it's misleading to treat this as a fall in the price for the purpose of guiding investors.
If you're doing your own calculations to see how much a stock has gone up over time or how its dividend has changed, make sure to look up when it's undergone splits so you can adjust for the changing share price over time.
Remember that stock splits don't actually lead to you owning more or less of the company, and they usually don't immediately affect your net worth, although in the long run, they may boost the value of your stock. They also don't have any ramifications for tax purposes and don't affect factors like 401(k) or Roth IRA contribution limits if you hold stock through a retirement plan.
Steven Melendez is an independent journalist with a background in technology and business. He has written for a variety of business publications including Fast Company, the Wall Street Journal, Innovation Leader and Ad Age. He was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.