Explainer: What are Stock Splits?

Every now and then a company will make the decision to implement a stock split. To make sure you’re not caught off guard, here’s our explainer on stock splits and how they affect investors.

How do stock splits work?

If a company is looking to increase the number of shares they have on offer there are a few options. Companies can elect to issue more shares to new investors, although this process generally has significant fees associated with it and can dilute existing shareholders’ ownership of the company. Or, another option is to engage in a stock split.

Stock splitting takes the number of existing shares and divides them up at a pre-determined ratio. Therefore, each individual share would be worth less but investors would have more shares, which when combined would equate to the same value. This option leaves the underlying value of the stock and the company unchanged.

Here’s an example of a stock split

Sally holds ten shares in Bob’s Bakery. Each share is worth $20 and together the value of her shares equates to $200.

Stock splitting before

 

Bob’s Bakery decides to split their stock 5:1. Therefore, each individual share now equates to five shares. This stock split means that Sally now has 50 shares in Bob’s Bakery and each one is worth $4. But the value of her holdings has not changed, it remains at $200.

Stock splitting

Why do companies stock split?

Typically, a stock split might occur when a share price is particularly high, making it unattainable from some investors. By engaging in a stock split a company can attract new investors and make it easier for investors to buy their shares. Stock splitting also improves the liquidity of the stock. With more stocks available the easier it is to buy and sell.

What are reverse stock splits?

A reverse stock split can occur when a company’s share price is trading quite low. The direct opposite of a stock split, this corporate action decreases the number of shares and in turn increases the price per share. A common reason a company may decide to reverse stock split is to meet an exchange listing requirement. Some exchanges specify a minimum bid price in order for a stock to be listed. If the stock falls below the bid price it risks getting de-listed.

Some companies might also want to increase their stock price to garner the attention of new investors and fend off the negative emotions associated with a low trading price.

Related article: Australia Share Market: Glossary of Common Terms

What to look out for

If a stock split occurs which affects your investment it may be worth finding out the underlying reason. This may help inform your decision to buy more shares, hold or sell your stock. It might also provide an insight to the current environment and potential future movement of your investment.

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Cover Image Source: Nemanja Novako (Shutterstock)

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