What is stock split?

A stock split is a corporate action taken by a company to divide its existing shares into multiple shares. The primary purpose of a stock split is to adjust the stock’s price and the number of outstanding shares without altering the overall value of the company or its market capitalization.

Stock splits are typically expressed in a ratio. For example, a 2-for-1 stock split means that for every single share held by an investor, they will receive two shares after the split. Similarly, a 3-for-1 stock split would result in three shares for each original share held.

Companies hold the belief that if their shares are priced too high, potential buyers may be discouraged from investing, even though this notion might not align with pure mathematical reasoning. Nonetheless, this perception holds significance in psychology, and numerous studies have provided evidence to support this notion.

For instance, consider a scenario where you own a stock initially trading at $10, but over time, its value increases significantly, reaching $200 per share. At this point, the company may perceive the stock as too expensive, potentially deterring potential buyers.

To address this, the company might decide to reduce the stock’s price by implementing a stock split. Let’s say they had one million shares priced at $200 each. Through the split, each share is divided into two, resulting in two million shares now valued at $100 each. Although the number of shares outstanding and their price change, the overall value of your investment remains the same. So, if you initially had one share priced at $200, after the split, you would own two shares, each valued at $100, maintaining the same total value.

Companies hold the belief that there exists an ideal price range, typically around $35, where investors find the stock attractive. It is a range that doesn’t make the company appear too cheap, indicating a weak business, nor too expensive, potentially deterring buyers.

However, it’s important to note that there is no definitive or optimal value for the stock price. Several studies have examined companies’ performance after stock splits and the demand for their shares post-split, leading to the conclusion that stock splits do not necessarily impact a company’s performance significantly. In other words, companies don’t actually need to conduct stock splits. Despite this, many companies still maintain the belief in the perceived importance of price ranges and continue to implement stock splits when their shares become too expensive.

The most prevalent method for companies to split their stocks is by dividing them into two shares. However, occasionally, companies opt for different split ratios, such as 1 to 3, 1 to 4, or any other suitable ratio.

What is reverse stock split?

A reverse stock split, also known as a stock consolidation or reverse split, is the opposite of a regular (forward) stock split. In a reverse stock split, a company reduces the number of outstanding shares by combining multiple shares into a single share. This results in a higher stock price per share without altering the company’s overall market capitalization.

To illustrate a reverse stock split, consider a scenario where a company’s stock price has significantly declined, reaching a very low value, for instance, 10 cents. In such a situation, the company may find it undesirable to have its shares trade at such a low price and decides to conduct a reverse split.

For instance, if the company has 1 million shares outstanding at 10 cents per share, they may decide to increase the stock price to $1 by implementing a reverse split of 10 to 1. This means that for every 10 shares an investor holds, they will be consolidated into 1 share. As a result, the total number of outstanding shares decreases, in this case, to one hundred thousand, while the overall value of the company remains unchanged.

After the reverse split, if an investor previously owned 100 shares at 10 cents each, they would now have 10 shares priced at $1 each. While the number of shares held by the investor decreases, the value of their investment remains the same.

In summary, a reverse stock split is used to increase the stock price and reduce the number of outstanding shares when a company’s stock price has declined significantly, typically to avoid trading at very low prices and to maintain compliance with exchange listing requirements.

Many stock exchanges impose minimum price requirements for companies to maintain their listing, and if a company’s stock price remains below that threshold for an extended period, it risks being delisted. To prevent this situation, many companies opt for a reverse split to increase the stock price and meet the exchange’s listing criteria. Additionally, numerous mutual funds have their own minimum price criteria for investing in stocks, often excluding those with a price below a certain threshold, such as $5.

Typically, a stock split is announced in advance, and if you have open orders, it’s advisable to manage them yourself rather than relying solely on your broker to handle the adjustments.

Yahoo Finance provides a calendar specifically for tracking stock splits.

stock split