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Stock Splits: What They Are and How They Affect Your Investment

Last updated 03/19/2024 by

SuperMoney Team

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Summary:
A stock split is a common corporate action where a company divides its existing shares into multiple new shares. The total value of the shares remains the same after the split, but the price per share reduces proportionally and the number of shares outstanding increases. Companies may choose to do a stock split to make shares more affordable and increase trading liquidity.
Stock splits are a common corporate action that can have a significant impact on investors. While many people have heard of stock splits, not everyone understands exactly what they are or how they work.
In this article, we’ll take a closer look at what stock splits are, why companies do them, and how they can affect your investments.

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What is a stock split?

A stock split is a corporate action in which a company increases the total number of shares outstanding by dividing its existing shares into multiple shares. This is typically done by a specific ratio, such as 2-for-1 or 3-for-1, meaning that each shareholder will receive two or three shares for every one share they previously owned.
While the total number of shares outstanding increases, the total value of the shares remains the same. For example, if a company with 1,000 shares outstanding at $100 per share undergoes a 2-for-1 stock split, it will end up with 2,000 shares outstanding at $50 per share. The total value of the shares, in this case, is still $100,000.
Stock splits do not affect the market capitalization of the company, which is calculated by multiplying the number of shares outstanding by the current market price of the stock. However, this action can have an impact on the trading liquidity of the shares. By making shares more attractive to individual investors — who may wish to buy smaller, more affordable shares — the company could see multiple benefits from a stock split.

Why do companies initiate stock splits?

A stock split could benefit a company for several reasons, though the exact reason will depend on the company’s financial standing. Here are some of the most common reasons a company may initiate a stock split.
  • Make shares more affordable. When the price of a stock increases too much, it may become too expensive for some investors to buy, particularly new investors with limited funds. By doing a stock split, a company can lower the price per share, making it more accessible to a wider range of investors.
  • Increase trading liquidity. A stock split can also increase the shares’ trading liquidity, which refers to how easily shares can be bought and sold. By reducing the price per share, a company can attract more individual investors who may want to buy smaller lots of shares. This increased demand can increase the trading volume and liquidity of the shares.
  • Signal confidence in future prospects. Sometimes, a company may do a stock split as a way of signaling its confidence in its future prospects. By increasing the number of shares outstanding, the company is effectively diluting the value of each individual share. However, if the company expects its earnings to grow and its stock price to rise, it may be confident that this dilution will be offset by the increased value of the company overall.
  • Meet exchange listing requirements. Finally, a company may initiate a stock split to meet exchange listing requirements. Some stock exchanges require that listed companies maintain a certain minimum share price or a minimum number of shares outstanding. If a company’s share price increased significantly, it may choose to do a stock split to reduce the price per share and maintain compliance with exchange listing requirements.

Pros and cons of stock splits

As with any investment decision, it’s important to consider the potential risks and benefits of a stock split and consult with a financial advisor before making any investment decisions.
WEIGH THE RISKS AND BENEFITS
Here is a list of the benefits and risks to consider.
Pros
  • Lower share price. A stock split can lower the price of a company’s shares, making them more affordable for smaller investors. This could potentially increase the number of shareholders and increase liquidity in the stock.
  • Increased trading volume. A lower share price can also increase the trading volume of a stock, as more investors may want to buy and sell at the new, lower price.
  • Positive signal to the market. A stock split can be seen as a positive signal to the market, indicating that the company is confident in its future growth prospects and wants to make its shares more accessible to investors.
Cons
  • No change in underlying value. A stock split does not change the underlying value of the company or the value of the individual shares held by investors. It is purely a numerical adjustment to the number of shares outstanding.
  • Perception of instability. In some cases, investors may see a stock split as a sign of instability or a lack of confidence in the company’s ability to maintain its share price at higher levels.
  • Administrative costs. A stock split can involve administrative costs, such as updating the company’s shareholder records and issuing new stock certificates, which can be a burden for smaller companies.

How do stock splits affect shareholders?

When a company initiates a stock split, it can have both direct and indirect effects on its shareholders.

Increase the number of shares

The most obvious impact of a stock split on shareholders is that it increases the number of shares they own. For example, if a shareholder owned 100 shares of a company’s stock before a 2-for-1 stock split, they would own 200 shares after the split. The total value of their shares would remain the same, but the number of shares they hold would double.

Reduce the price per share

Because the total value of the shares remains the same after a stock split, the price per share reduces proportionally. This means that shareholders will see the price of their individual shares decrease, but the total value of their investment will stay the same. In some cases, a lower share price may make the stock more attractive to potential buyers, increasing demand and potentially driving the price up over time.

Impact on dividends

A stock split does not directly impact a company’s dividend payments. However, if a company chooses to increase its dividend payout after a stock split, shareholders may see a higher total dividend payout as a result of owning more shares.

Psychological impact

Finally, stock splits can have a psychological impact on shareholders. For some investors, a stock split may signal that the company is doing well and has confidence in its future prospects. This can lead to increased confidence in the stock and potentially attract new investors.

Key Takeaways

  • A stock split is a common corporate action where a company divides its existing shares into multiple new shares.
  • The total value of the shares remains the same after the split, but the price per share reduces proportionally and the number of shares outstanding increases.
  • Companies may choose to do a stock split to make shares more affordable and increase trading liquidity.
  • The impact of a stock split on a shareholder’s investment depends on their individual situation and investment goals.

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