What Is A Stock Split (Explained: All You Need To Know)

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What is a Stock Split?

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Let me explain to you what Stock Split is and why it’s important!

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What Is Stock Split

A stock split refers to the increase in the total number of shares outstanding by a company on the stock market.

In other words, when a stock splits, a shareholder will receive additional shares for each share of stock held in a company.

Typically, companies will perform a stock split to increase the stock’s liquidity in the market and lower the stock price so it becomes more affordable to purchase.

For example, a company may have 100M shares outstanding where each share of stock is worth $20 per share.

If the company performs a 2-for-1 stock split, it will double its total number of shares outstanding from 100M to 200M but the stock price will go from $20 per share to $10 per share.

This is the case as the stock split does not impact the company’s total market capitalization.

In our example, the company’s total market capitalization was $2B (100M shares X $20) before the stock split and remains $2B (200M shares X $10) after the stock split.

Very often companies will perform a stock split based on a 2-for-1 or 3-for-1 split ratio.

Keep reading as I will further break down the meaning of a stock split and tell you how it works.

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Why Is A Stock Split Important

Companies use the stock split mechanism to create additional liquidity for their shares and attract more investors.

Many investors may not be comfortable purchasing one share of stock worth $1,000 but they will be more comfortable if the stock is priced at $100 per share.

A company with a stock price of $1,000 per share may want to increase its stock price to $10 per share by performing a 10-for-1 stock split.

This means that a shareholder holding 1 share of stock will end up with 10 shares but the stock price will go from $1,000 per share to $100 per share.

At $100 per share, not only is the price range more comfortable for many investors but there are ten times more shares outstanding thereby increasing the stock liquidity.

Although there may be other reasons justifying a stock split, in most cases, companies are looking to bring the stock price down to a price range allowing them to attract the optimal number of investors.

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Stock Split Benefits

There are a few key benefits to performing stock splits.

The most important benefit of doing a stock split is to bring the stock price down when it becomes expensive for investors.

For example, a company doing well will see its stock price continually rise over time.

At some point in time, if the stock price rises to very high levels, fewer investors may be willing to commit a lot of money to purchase a board lot.

The second most notable reason why companies will consider splitting their stock is to create additional liquidity in the market.

Typically, the general public will purchase shares from shareholders who are looking to sell (these shares are called float shares).

If the company’s float is too small, then buying and selling activities may be affected as there are not many shareholders in the market looking to sell their shares.

Stock splits will increase the company’s float, allowing more investors to purchase company shares.

Another benefit of a stock split is that investors see that as a favorable thing.

Stock splits are seen as signs that a company is doing well and they create renewed interest in the company’s stock.

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Stock Split Drawbacks

Although there are many benefits to performing a stock split, there are also certain drawbacks to consider.

The most notable drawback of a stock split is that the company has to go through an expensive regulatory oversight and approval process before splitting its stocks.

In other words, the company will need to go through an entire legal review process for something that does not contribute to increasing its overall market capitalization.

Another downside to a stock split is that if the stock price drops too low, you may have the wrong type of investors buying and selling your shares.

For example, there are many day traders that are looking for arbitrage opportunities or purchase stocks below a certain price.

Since a stock split reduces the price per share, the company may end up attracting the wrong type of investors.

Finally, it’s important that companies do not split their stock in such a way that the price falls too much and they risk violating their listing compliance requirements.

For instance, companies listed on the NASDAQ are required to maintain a stock price of at least $1 for thirty consecutive days or else they will end up getting a compliance warning from the exchange.

As a result, a company splitting its stocks must ensure that it maintains a large enough buffer for normal price fluctuations and remains compliant with the exchange rules.

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Stock Split vs Reverse Stock Split

What is the difference between a stock split and a reverse stock split?

A stock split is when a company splits its stocks into more shares.

For example, a 5-for-1 stock split will increase a company’s total shares outstanding by five folds.

Typically, companies will consider stock splits to bring their stock price per share to a more optimal range and increase liquidity.

On the other hand, a reverse stock split has the exact opposite effect.

For example, if a company performs a 1-for-5 reverse stock split, it means that it is looking to reduce the total number of shares by a ratio of 5 to 1.

As a result, a shareholder having 50,000 shares will end up with five times less after the reverse stock split (giving 10,000 shares).

Typically, a company will go through a reverse stock split to increase its stock price to avoid being delisted by the stock exchange.

Also, some funds and mutual funds have policies where they do not invest in stocks below a certain price per share.

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What Is A Stock Split FAQ

Why do companies split their stock?

A stock split is a good strategy for a company to attract more investors and increase its stock liquidity in the market.

For instance, some investors may not want to invest in a stock at $500 per share but will be more inclined to do so at $100 per share.

Also, if a company has a small float, a stock split will help increase stock liquidity allowing more investors to trade the stock in question.

Does a stock split affect company valuation?

A company’s market capitalization or valuation does not change if the shares are split.

For example, if a company has 100M shares outstanding at $10 per share, it has a total market capitalization of $1B.

If the company does a 2-for-1 stock split, it will increase its total number of shares outstanding to 200M but the stock price will drop to $5 per share.

This way, the total market capitalization remains at $1B.

What is an example of a stock split?

Let’s look at an example of a stock split to better understand the concept.

Very often, companies will perform either a 2-for-1 stock split or a 3-for-1 stock split.

If Company ABC has 100,000 shares outstanding at $100 per share, it has a $10M market capitalization.

If the company does a 2-for-1 stock split, it will then increase its outstanding shares to 200,000 but the stock price will drop to $50 per share.  

However, its total market cap of $10M will remain unchanged.

What are common stock split ratios?

The most common stock split ratios are 2-for-1 and 3-for-1 stock splits.

However, a company can decide on any stock split ratio that it considers appropriate, such as:

• 4-for-1
• 5-for-1
• 10-for-1
• 4-for-3
• 5-for-2
• 5-for-4

Is a stock split taxable for the shareholders?

A stock split is generally not a taxable event for the shareholders as they have not disposed of their shares. 

However, if a shareholder sells some of the shares obtained through a stock split, that transaction will be a taxable transaction.

For example, a shareholder has 1,000 shares of Company ABC and receives another 1,000 shares through a 2-for-1 stock split.

This transaction is not taxable.

However, the shareholder then sells 500 of the additional shares obtained.

This transaction is taxable.

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Takeaways 

So there you have it folks!

What is the meaning of a stock split?

In a nutshell, a stock split is a type of corporate action where a company increases the total number of shares outstanding while at the same time decreasing the price per share.

Generally, a company that is doing well will see a gradual rise in its stock price.

However, if the stock reaches a price too high, it may be difficult for a number of investors to purchase the stock that is expensive in price.

With a stock split, the company is able to bring the stock price down allowing more investors to potentially invest in the company’s stocks.

Typically, a stock split is seen as a favorable thing as it signals that the company has confidence in its future prospect.

Now that you know the meaning of a stock split and how it works, good luck with your research!

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