A “stock split” and a “reverse stock split” are tools that public companies can use to adjust the number of shares in circulation. Understanding how these splits work will give you a better perspective on how this process can affect a stock’s price. A good grasp on these will allow you to make more informed decisions when it comes to managing your portfolio.
What is a stock split?
This is when a publicly listed company increases the number of its shares by issuing additional shares to existing shareholders. It involves dividing a current share into pieces that become multiple individual shares.
This is sometimes called a “forward stock split”. Taking this action effectively reduces a stock’s price because the market capitalisation stays the same but is divided by a larger number of shares. However, shareholders don’t lose out. Because, the combined price of their new, lower-price shares will add up to be the same as the original pre-split stock price.
For example, with a 2-for-1 split, you’d receive one extra share for each share you own. In this scenario, the stock price will be halved so that after the split, each share will be worth half the pre-split price. But together, the value of your 2 shares will be the same as the original price of a single share before the split.
What is a reverse stock split?
This involves reducing the number of shares in circulation. When a company declares a reverse stock split, it means a single outstanding share is converted into a fraction of a share. The size of your new fractional share will depend on the size of the reverse split.
For example, a 1-for-5 reverse split means that each share you own will now be worth 0.2 (one-fifth) of a share. So, to own a full single share of a stock after the split, you’d need to have owned 5 individual shares before the reverse split.
What is the main difference between the two?
A stock split will increase the number of shares available on the market, reducing the price of a single share. Whereas, a reverse stock split will decrease the number of shares in circulation, increasing the price of a single share. It’s as simple as that.
Stock split ratios
It’s worth understanding how stock split ratios work. Whether a company decides on a regular stock split or a reverse stock split, it will select a ratio in advance that determines by how much the number of shares will increase or decrease.
Why do stock splits occur?
The exact reason will vary. But, some of the most common motives for companies to engage in a stock split include the following:
Making the stock’s price appear more affordable to investors.
Buying stock can become more realistic for investors who don’t have access to fractional shares.
Reducing a stock’s price if the nominal level appears much higher than similar companies.
Increasing the liquidity of a stock by making more shares available.
Why would a company carry out a reverse stock split?
Here are a few of the most popular reasons for a reverse stock split:
To boost a stock’s price and possibly improving investors’ perception of a company and its image.
Prevent delisting from an exchange, which can happen if a share price falls below a certain level.
As a marketing tactic to attract more attention and eyeballs from investors and analysts who disregard penny stocks or shares with low price tags.
Does a company have to announce its stock splits?
Yes, the company will first need its board of directors to approve the intention to carry out a split. Then, once the split has been voted on and agreed upon, it will inform the regulators. The company will also announce when the stock split is due to take place. However, a company can choose when to make this announcement to maximise the effect. The order of announcements usually goes like this:
Date of the announcement. A company will usually make a public statement about a stock split, details around the ratio and when the split will take place.
Record date. This is the date by which investors need to be holding the stock to qualify for the new shares created by the split. But, it’s mostly for accounting purposes and if you buy or sell between the record and effective dates, the right to own the new shares transfers.
Effective date. This is when the split-adjusted number of shares will be visible to investors.
What happens to the stocks I own if they split?
On the effective date that the stock split takes place, you’ll automatically be issued more shares. How many additional shares you receive will depend on the size of the split ratio. The resulting price of each share will also be based on the new total number of shares.
Does a split affect the price of the original stock?
A split will increase or decrease the price of the stock. This will depend on whether it’s a regular stock split or a reverse stock split. But you won’t become poorer or richer because these splits do not alter the total market capitalisation or value of a stock.
A company’s value stays the same. So, even though the share price will change, your new total number of shares will be worth the same amount as before the split.
What is an example of a company splitting its stocks?
A hugely reported example is the multiple stock splits carried out by Tesla (TSLA). Another big company to carry out a long-awaited stock split was Amazon.com (AMZN). One recent instance of a reverse stock split is General Electric (GE). GE carried out a 1-for-8 reverse split, reducing its total shares from 8.8 billion to roughly 1.1 billion.
A short seller is someone who bets on the price of a stock decreasing by borrowing shares and then immediately selling them. Their profit or loss is the difference between the new share price and the price at which they initially borrowed the shares. Unfortunately, short-selling a stock before a split isn’t a cheat code to make more profit. The original trade will effectively stay the same, but the number of shares shorted and the price per share will automatically adjust in line with the stock split.
So, if a short seller borrows 100 shares before a 5-for-1 split, they’ll have to give back 500 shares. They’ll buy back the 500 shares at the new market price before returning them, making them no better or worse off.
Bottom Line
Stock splits and reverse stock splits are useful tools that companies can use to adjust the number of shares in circulation to a higher or lower level.
For the most part, these adjustments have a neutral impact over the long run. However, stock slices and splits do affect the price of individual shares. This can sometimes have a psychological effect on investors or provide a publicity boost that can lead to more positivity or negativity about the company issuing the stock split. But, when a split takes place, it does not alter the value of a company, just the price and number of its shares.
Frequently asked questions
The total number of shares increases by a set amount and the price of each share will reduce by an amount proportional to the size of the stock split.
It depends on the reasons behind the decision for the split. A split can be beneficial to shareholders if there is a bullish sentiment around the decision. But, the move could be seen as a bearish sign of desperation if the stock was already struggling.
No, you won’t lose money. Initially, the price of each share will be lower, but your total holdings will be worth the same amount as before the split. A stock’s price may go lower after a split or for other reasons, but the split itself does not lead to you losing money.
There’s no perfect answer. Some stocks have become more popular after a split and others have become less popular. It depends on the investment itself and also the reasoning behind the decision to carry out a stock split.
No, for the most part, a stock split is a psychological adjustment to the share price. However, a split can be viewed as a good or bad decision depending on the situation, which means the result for shareholders can be either positive or negative.
It depends on the company. There have been some recent positive cases of a big company carrying out a split, for example, each Tesla (TSLA) stock split was a successful move. But this doesn’t mean it’s always a good idea.
George is a deputy editor at Finder. He has previously written for The Motley Fool UK, Nasdaq, Freetrade, Investing in the Web, MoneyMagpie, Online Mortgage Advisor, Wealth, and Compare Forex Brokers. He's focused on making personal finance and investing engaging for everyone. To do this he draws from previous work and his Level 4 Diploma for Financial Advisers (DipFA), sharing what he’s learnt. When he’s not geeking out about money, you’ll find him playing sports and staying active.
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