What Investors Need To Know About Stock Splits
PEGGY VYBORNY, CPA
From time to time, public companies announce stock splits or reverse stock splits. If this happens to a stock you own, it is important to understand what these terms mean and, perhaps more important, what they do not mean.
Pieces of the pie
A stock split occurs when a public company divides its existing shares, resulting in a greater number of them. Typically, this is accomplished by exchanging each existing share for multiple shares of the same company’s stock. This process does not change the company’s overall market capitalization, nor does it change the company’s value or an individual investor’s holdings. Rather, it increases the number of outstanding shares while proportionately reducing the price per share.
Think of a company’s market cap as a pie — cutting the pie into smaller pieces does not change the total amount of pie. For example, a company has five million shares outstanding, currently worth $10 per share, for a total market cap of $50 million. If the company facilitates a two-for-one (2:1) stock split, it ends up with 10 million shares worth $5 per share, but its market cap remains $50 million. Similarly, an individual investor who owns 500 $10 shares of the company before the split will own 1,000 $5 shares after the split.
Reasoning behind it
Usually, when a company announces a stock split, it is because management believes the stock price has gotten too high relative to its peers and that a lower price will boost liquidity. Let us say that two companies are otherwise comparable, but one’s stock is trading at $500 per share and the other’s is trading at $100 per share. Smaller investors may be more likely to invest in the company with the lower stock price. A stock split may also help draw attention to the company’s strong performance and signal management’s confidence in its future prospects.
Yet contrary to what some investors may believe, a stock split does not increase the value of their holdings overnight. As already noted, increasing the number of shares while proportionately reducing the price has no direct impact on value. However, it is possible that a stock split will increase demand by highlighting the stock’s recent performance and making it visible to a new pool of investors. There is no guarantee that a stock’s price will rise. In fact, it might fall and you could lose the money you have invested. But stock splits can result in higher short-term prices.
A reverse stock split is the opposite of a regular stock split. A company combines its existing shares into a smaller number of higher-priced shares. For example, if a company with 10 million shares worth $2 per share undergoes a one-for-five (1:5) reverse stock split, it will end up with 2 million $10 shares.
Like a regular split, a reverse split does not directly affect the value of shares. But it may be a red flag that the company is struggling. That is because public companies often conduct reverse stock splits when the price has dropped below a stock exchange’s minimum threshold and is at risk of being delisted. However, a reverse split is not always a bad sign. For instance, a company may believe that increasing its share price will enhance its visibility among institutional investors.
Review the fundamentals
At base, stock splits and reverse stock splits are neither positive nor negative. But the reasons behind a company’s decision to split stock may be significant. If a company whose stock you own announces such a transaction, revisit the underlying fundamentals of the business and evaluate its future prospects. Your ORBA financial advisor can help you determine whether such securities belong in your investment portfolio given your situation and goals.