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A stock split is exactly what the name implies: A company takes its existing shares and splits them up into smaller pieces.
Doing this decreases the price per share of a stock, helping to attract new investors and boosting liquidity for the company. A stock split has no effect on an existing shareholder's ownership position—they'll just own more shares after the split.
A stock split is generally seen as an encouraging sign that a company is doing well. Its stock price is high enough that it could be scaring off new investors. Lowering the price per share through a stock split can make it more accessible. Here's a closer look at how a stock split works and what it means for investors.
How a Stock Split Works
During a stock split, a corporation essentially slices existing stock shares into smaller units. This, in turn, makes individual shares more affordable. It does not involve issuing new shares, which would water down your ownership stake if you're a current shareholder.
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Typical stock split ratios are 2-for-1 or 3-for-1. This means that, for every previously held share, you'll now have two (or three) shares after the split. If a stock split doesn't leave you with an even number, you might end up with fractional shares. Split stocks do not alter the total value of your stock holdings.
Here's an example: If you held 20 shares valued at $6 per share before a 2-for-1 stock split, the total value of your investment is $120. Immediately after the split, you'll own 40 shares at $3 per share, still worth a total of $120. The total value didn't change. Neither did your equity, but you are left with double the number of shares.
Let's look at Amazon's recent 20-for-1 stock split as another example. Amazon's shares closed at $2,447 on the last trading day before the split. If you'd owned one share after the split, it would have automatically converted to 20 shares at around $122 per share. It's important to note that a stock split doesn't make the issuing company more or less valuable. Regular market activity will continue to affect stock prices—for better or worse.
Why Do Companies Split Their Stocks?
Initiating a stock split makes shares more affordable. With the Amazon example just mentioned, many investors would be reluctant (or financially unable) to buy individual shares at well over $2,000 each. Splitting stock is meant to reduce that barrier to entry so that more investors can buy in. This might spark interest from new investors, which could unlock more liquidity for the company.
Stock splits aren't new. Apple, for instance, has split its stock five times since going public. The most recent was a 4-for-1 split in August 2020.
What Is a Reverse Stock Split?
A traditional stock split is sometimes called a forward stock split. Reverse stock splits are on the other end of the spectrum and are meant to drive up share prices.
With a reverse split, every outstanding stock share is converted into a fraction of a share. For example, a 1-for-5 reverse stock split means that every five shares change over to a single share. So if you originally held 1,000 shares, you'd now have 200.
There are several reasons why a company might call for a reverse split. They might feel the current trading price is too low to entice investors. In other cases, a reverse split might be necessary to meet minimum listing price requirements to continue trading on a specific stock exchange. Reverse stock splits aren't necessarily a bad thing, but they often come on the heels of a sharp decline in share prices. This on its own could make investors uneasy.
In some cases, a reverse stock split can directly impact investors. GE, for example, called for a 1-for-8 reverse stock split in July 2021. Remember how stock splits can sometimes result in fractional shares? For existing shareholders whose shares couldn't be evenly divided by eight, GE issued cash payouts instead of fractional shares, decreasing investors' overall holdings.
How Does a Stock Split Affect Investors?
When stock splits occur, they're converted automatically: Investors don't have to take any action. You also don't have to pay taxes on any additional stock you receive through a split because your total base doesn't change. You won't report income unless you incur gains after selling shares.
Current shareholders who hold stock over the long term could benefit in other ways from a stock split. An increase in liquidity could provide the company with an infusion of capital that ultimately improves the business—and potentially drives up stock prices even more. In other words, it could strengthen your investment. Either way, stock splits will not affect your equity or dividends.
If you want to take advantage of more affordable prices and buy in after a stock split, be sure the stock fits into your overarching investment plan. Diversifying your investment portfolio with a mix of high- and low-risk investments is considered a safer approach than strictly buying individual stocks. With that said, a stock split could create an opportunity for you to buy stock in a company that's aligned with your values or simply meshes well with your portfolio.
The Bottom Line
A forward stock split is one way a company can lower its stock price and make it more accessible to new investors. It automatically converts existing shares into smaller pieces. On the flip side, a reverse stock split increases share prices and consolidates existing shares. Understanding the difference can help explain why trading prices might literally change overnight. It may also entice you to buy shares of a stock that's previously been out of your price range.
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