What is a Stock Split?
Have you ever wanted to purchase shares of a company, but you were deterred because you thought the price was too high? Then seemingly out of the blue, the stock price is cut in half allowing you to buy the shares at a better level.
In many instances, the reduction in the stock price occurs because of a stock split. The action of increasing the number of shares that are outstanding and simultaneously reducing the stock price is called a stock split.
A forward stock split is issued by the board of directors of a public company. The board of directors could double the number of shares outstand and halve the price of the stock.
They could also increase the number of shares by a greater number which would decrease the stock price by to same ratio.
- A 2-for-1 stock split, with 10 million shares outstanding and a stock price of $50, would increase the number of shares issued to 20 million, and the stock price would drop to $25.
- A 4-for-1 stock split, with 10-million shares outstanding and a stock price of $50, would increase the number of shares issued to 40 million, and the stock price would drop to $12.5.
Why Would a Company Split Its Share Price?
There are several reasons why a company could benefit from a stock split. The perception that the price of a stock is too high, might deter some retail investors from purchasing shares.
To avoid scaring off some investors, a company can split its stock which would bring down their share price putting the shares in a range that will attract investors.
Additionally, a stock price that is elevated may reduce the volume of the shares that are traded. This reduces the liquidity of the shares.
By expanding the number of shares that are outstanding and lowering the price a company can aid the liquidity of the shares.
The underlying reason for the split is to add to trading volume because the price of the stock is lowered to a trading price that is deemed more comfortable by most investors.
Human psychology dictates that investors believe that the price of a stock at $100 is more expensive than the price of a stock when it is at $10.
Investors are more comfortable in general purchasing 100 shares at $10 per share then purchasing 10 shares at $100 per share. Many investors also believe there is more upside to a stock when the price is lower.
Some think there is a better chance that the price of a stock at $10 will double to $20 then a stock price that is at $100 doubling to $200.
Therefore, when the share price has risen substantially, most public firms will end up declaring a stock split at some point to reduce the price to a more popular trading level.
How Does a Stock Split Affect Your Investment?
If you are already an investor in a stock ahead of a stock split, there is no change to the value of the equity after a stock split. Here is why.
Let’s assume that you own 10 shares of company XYZ and the price of those shares is $100 per share. The total value of the shares you own equals $1,000 (10 shares * $100 per share).
On the day of the 2-1 stock split, you will own 20 shares of company XYZ at a price of $50 per share which equals $1,000. The split has no effect on the value of the shares that you hold in your portfolio.
What Happens When a Stock Split Occurs?
Although the number of shares outstanding increases during a stock split, the total dollar value of the shares remains unchanged.
Some investors believe a split is a signal to purchase shares, as new investors rush in to buy shares at a lower price.
Historically, the price of a stock will rise after a split according to studies conducted by Chairman of the Finance Department at the University of Illinois at Urbana-Champaign David Ikenberry performed in 1996 and 2003.
Ikenberry’s studies show that during the year following a stock split shares that split outperformed the broader market by 8%. In the three years that follow the split the shares that split outperformed the broader market by approximately 12%.
Ikenberry evaluated over 1,000 stocks for each study, including 2-for-1, 3-for-1 and 4-for-1 stock splits.
The psychology of a split is to lower the price and entice investors to trade more shares.
There are also actions called reverse splits which increase the price of the share and reduce the total volume of the shares that are outstanding.
The reason a company would engage in a reverse stock split is to reduce the chance that the share price would fall below the minimum price required by the stock exchange where it is listed.
Here are some examples of requirements issued by the New York Stock Exchange to list and maintain shares on the exchange.
- Initial listing requirements
- Minimum trading price
- Minimum penalty
- Minimum suspension
In addition to having at least 400 shareholders, with at least 1.1 million shares available to the public and a market value of the public shares of at least $40 million. Each stock must have a minimum value of $4 at the time of listing.
Minimum Trading Price
Once a stock is listed, stocks must maintain a minimum price of $1 per share.
If an NYSE listed stock closes or ends the trading day below $1 for 30 consecutive days, it is a candidate for delisting or removal from NYSE trading.
The NYSE can suspend its minimum price requirement.
A reverse stock split can be a warning signal. If a company performs a 1-2 reverse stock split, increasing its share price from $1 to $2, they are likely attempting to buoy the share price, reducing the risk that it will fall below the $1 threshold.
Often the price action is telling you that something is wrong when the share price of a company cannot remain above the exchange’s minimum listing price, and caution is advised when considering this type of investment.
Why Do Companies Use a Reverse/Forward Split
You should be aware that not all reverse stock split strategies signal that there is something wrong. A reverse/forward stock split is a strategy used to eliminate shareholders who do not own the required number of shares to participate in a split.
The strategy is designed to reduce administrative costs by decreasing the number of outstanding shareholders who might require documents such as voting proxies.
This is a strategy is used by a company to force investors to purchase more shares at a lower price to participate in a forward split. Here is an example.
Let’s assume that prior to a reverse stock split, you own 90 shares of ABC stock at a price of $5 per share.
The company announces a reverse stock split where the price will double to $10 per share and the number of shares you will own after the split will be reduced to 45.
Following a reverse-split, the company announces a forward 2-1 stock split, for investors who hold at least 50 shares. If you still hold 45 shares at $10 per share, you will not qualify for the split.
Since the price would drop by $5 per share, due to the stock split, you either be forced to cash out before the split or purchase an additional 5 shares to push your holdings up to 50 shares.
The key takeaway is that stock splits are issued by firms for several reasons including increasing liquidity, reducing the price of the shares, buoying the price of the shares and reducing administrative costs.
The most common type of stock split is a forward stock split. Here the number of shares is increased, and the price of the stock is reduced by the same ratio. The goal is to increase volume and liquidity by attracting investors to a lower share price.
There are also reverse stock splits. A company will use this type of stock split to increase the share price, to avoid having the share price fall below the minimum threshold which is fixed by the trading exchange.
There are also strategies that are used by companies to flush out investors who have low shareholding to reduce administration costs.
A reverse/forward stock split is a strategy where the company reduces the share count and increases the stock price and then subsequently announces a forward stock split.
The company can state that the number of shares that need to hold must exceed a minimum threshold.
This can force investors to cash out if they are unwilling to purchase more shares to reach the minimum threshold.
A forward stock split does not necessary signal a buy signal for an investor. A reverse stock split can signal there is trouble ahead for a company, but also can mean they are engaging in other strategies to reduce administrative costs.