Stock splits are rare but significant events in the life-cycle of a publicly-traded corporation. Both the number of shares outstanding, as well as the market price of a stock can move dramatically in response to a stock split. The price of the stock can both appreciate and depreciate, depending on the kind of split. Understanding stock splits is mandatory for any investor.
In a stock split, each of the existing shares is replaced by multiple new shares; the old stock literally splits into several new ones. The number of new shares that replace each old share is known as the split ratio. In a split with a split ratio of four-to-one, for example, each old share is removed from circulation and replaced by four new shares. If you had 500 shares in your account before the split, you will have 2,000 new ones after the split. The number of total outstanding shares of the issuing corporation will grow fourfold after the exchange.
A reverse stock split is the exact opposite of a regular stock split. In this case, several old shares are replaced by one new share, and the company's share-count declines. Had the four-to-one split in our example been a reverse split, your 500 old shares would have been replaced by 125 new ones and the company's share-count would have gone down by a factor of four. Whether the split is a regular one or a reverse split, the shareholders take no action at all. The brokerage company handles the exchange of old shares for new ones on your behalf.
Price Adjustment in Regular Split
After a regular stock split, the price of the shares goes down and the price of the new shares are lower than the price of the old share. This is because the entire corporation, which you can think of as the pie, is worth the same as before but now split into many more slices. Each slice is, therefore, worth less. In a four-to-one split, the price of four new shares equal the price of one old share, and the total worth of your portfolio remains the same.
Price Following Reverse Split
After a reverse stock split, the stock price rises. In a four-to-one reverse split, the price of the new share should be four times higher than the old shares. Once again, the total worth of an investor's holding remains the same. In fact, both regular and reverse splits are instituted to change the stock price of the issuing company. If the stock price has risen too fast and purchasing even a single lot of 100 stocks is unaffordable for most investors, a stock split is likely to follow. If the stock price has declined too far and falls below the minimal price floor that is required to keep the stock listed in a public stock exchange, the issuing firm will likely announce a reverse split.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.