What is a Stock Split?

A stock split is a corporate decision that a company can make to increase the number of shares that it has outstanding on the market, usually in order to improve liquidity and make the investment more accessible. Though a stock split will not affect the underlying value of the asset that you own, understanding how a stock split works can help you better plan your investment strategy. Read on to learn everything you need to know about a stock split. 

What is a Stock Split?

Before explaining what a stock split is and how it works, imagine this scenario. You have $2,000 in your investing account and you have the option to invest in either Company A or Company B. Both companies have the same basic fundamentals — the only difference between the two is that Company A’s stock costs $20 a share, while Company B’s stock is currently priced at $1,000 a share. This means that with your investment funds, you can choose to purchase 1,000 shares of Company A’s stock or 2 shares of Company B’s stock. Which one do you think you’d choose?

If you’re like most investors, you probably choose Company A because you’d have the ability to purchase more individual shares. Most people are more comfortable purchasing a larger number of lower-priced shares than they are purchasing a few shares of a highly-valued stock. If a company’s stock price rises too high, the company might declare a stock split in order to keep the price of the stock lower for improved liquidity.

When a company declares a stock split, it means that the company will be increasing the total number of shares of the company that is outstanding without changing the company’s total market capitalization. The total number of shares that will be added to the pool of investments is determined by the split ratio chosen by the company. The most common ratios for stock splits are 2-for-1 and 3-for-1; however, a company’s board of directors can choose nearly any ratio that they believe will best serve the company. The first number in each ratio represents how many additional shares of stock will be added to the total investment pool per each share currently outstanding.

If Company B from the example above wanted to improve its liquidity, it might order a 10-to-1 stock split on its shares currently valued at $1,000 a share. This means that for every 1 share of Company B’s stock that’s currently available on the market, 10 additional shares will be added. Because a stock split does not affect the total value of the company, this means that after the stock split, each share of Company B’s stock will be worth $100. 

What is a Reverse Stock Split?

A reverse stock split is simply the opposite of the situation described above. Instead of adding shares to the market to lower the price of each individual share, companies may declare a reverse stock split in order to increase the value of each share on the market. A reverse stock split does not change the value of the company issuing the stock in the same way that a standard stock split does not affect the total market capitalization of the company. Companies usually call for reverse stock splits in order to increase the market visibility of the company issuing the stock or to meet value requirements put in place by the SEC to prevent the stock from being delisted from major exchanges.

An example of a reverse stock split might include the following scenario. Imagine that Company C has 10,000,000 shares of stock outstanding and that its stock has been trading at a value of $0.35 for a significant period of time. If Company C’s stock is listed on the New York Stock Exchange (NYSE), this means that the company would be at risk of being actively removed from the exchange if it does not begin trading at a value of $1 a share or higher.

In order to remain on the exchange, Company C might declare a 1-to-10 reverse stock split. At the end of the split, Company C would only have 1,000,000 shares of stock outstanding; however, each share would be valued at $3.50 a share instead of $0.35. This means that Company C’s stock is now trading above $1 a share, and the company can remain listed on the NYSE. 

How a Stock Split Works

When a company that you own stock in carries out a stock split, you’ll likely notice a change in the number of shares of that company that you own when you open your brokerage account. However, the value of the shares in your account will not change — the company issuing the split will ensure that you have an equivalent value in stock following the closing of the split. For example, if a company’s stock is trading at $100 a share and you own 1 share, you’ll see 2 shares valued at $50 each in your account following a 2-to-1 split.

Some companies refer to the process of rebalancing the number and value of shares in your account following a stock split as a “special stock dividend.” Despite having the word “dividend” in the name, this does not mean that a stock split replaces the standard dividend period that you’d typically expect if you’re investing in a company that pays out a dividend to shareholders.

If you own a stock that experiences a stock split or reverse stock split, this decision will not have an effect on your taxable income. The additional shares that you receive are not considered to be taxable income under the IRS, and the tax liability of each share that you previously owned will be divided or compounded according to the type of split or reverse split that the company’s shares have undergone.

What are the Positive Aspects of Stock Splits?

Stock splits can benefit both companies and investors. They often improve market perception and increase liquidity. By splitting existing shares into multiple ones, a company can lower its stock price. This makes shares more accessible to a wider range of investors and can increase demand. Lower-priced shares may attract more trading activity as investors find them appealing. Stock splits can also enhance a stock’s marketability, appealing to both institutional and retail investors. Additionally, they typically show a company's confidence in future growth. Stock splits often follow significant stock price increases, signaling positive performance. This can enhance a company’s visibility in the market, benefiting shareholders and potential investors alike.

Increased Liquidity

One significant advantage of stock splits is the increased liquidity they provide. When a company performs a stock split, the price per share decreases while the total number of shares increases. This price reduction makes the stock more affordable for more investors, especially retail investors with limited capital. Increased affordability can lead to higher trading volume, as more investors buy and sell shares. Higher trading volumes lead to smoother transactions and reduced price volatility. This makes the stock more attractive. Additionally, increased liquidity can enhance market efficiency and allows for more accurate price discovery. In summary, stock splits can foster a more active trading environment and encourage participation from various investor groups.

Psychological Appeal

A lower share price can significantly impact investor psychology. Many investors see stocks with lower prices as more accessible. They consider these stocks to be better investment opportunities, even if the company’s fundamentals haven’t changed. This perception of affordability can create a sense of value and opportunity. It motivates investors to buy shares they might ignore at a higher price. The ability to own multiple shares rather than just one high-priced share can also increase investor satisfaction. As more investors buy, the increased demand can push the stock price higher. This can create a cycle of rising prices and growing interest. This psychological factor is important for maintaining investor enthusiasm and confidence. It may positively affect overall stock performance in the long term.

Broader Investor Base

Stock splits can widen a company's investor base. They make shares more affordable for a variety of investors. Lower-priced shares attract retail investors as well as smaller institutional investors. This can lead to a more diverse ownership structure, which is beneficial for the company. A varied investor base can enhance stability. It reduces the risk associated with having a few large shareholders who can disproportionately influence stock prices. Attracting more investors can also indicate widespread interest in the company. This can improve the company's reputation and lead to a better valuation. In the long run, a broader investor base can help the company succeed by creating a stronger market for its shares. It positions the company to handle market fluctuations and seize growth opportunities.

Drawbacks of Stock Splits

Stock splits are often viewed positively by investors. Companies use them to make shares more accessible and increase liquidity. The announcement of a stock split can create excitement and draw attention. However, there are drawbacks to consider. A stock split does not change a company's market capitalization; it only increases the number of shares. This can give a misleading impression of growth. The process of executing a stock split may lead to administrative costs. It can also divert management's focus from core business operations. Some investors might mistakenly see stock splits as a sign of financial strength. This could result in poor investment decisions. Understanding the downsides of stock splits is important for investors. It helps them make informed choices in the stock market.

No Fundamental Change

One main drawback of stock splits is that they do not change a company’s fundamentals or overall market value. A stock split only alters the number of shares outstanding and adjusts the share price proportionally. The company’s financial health, assets, and earnings remain unchanged. This can mislead investors. They may mistakenly believe the split indicates an improvement. As a result, some investors might make decisions based on this perception. They could invest under false assumptions. This disconnect between share price and actual performance can cause market inefficiencies. The stock price may not accurately reflect the company’s true value. While a stock split can create an illusion of growth, it does not address the core factors that drive a company's success, such as revenue, profits, and strategic direction.

Potential for Increased Volatility

Stock splits can lead to increased volatility in stock prices. After a split, the lower share price often attracts more investors, especially retail investors. This can result in higher trading volumes. While increased liquidity is beneficial, it can also cause greater price fluctuations. New investors may react to short-term price changes rather than the company’s fundamentals. This can create sharp price movements that do not reflect the company’s actual performance or market conditions. Additionally, significant price swings can lead investors to make decisions based on emotions like fear or excitement, rather than rational evaluations of long-term prospects. This unpredictability may discourage risk-averse investors from participating in the market.

Cost of Administrative Changes

Implementing a stock split can incur various administrative costs. This is particularly burdensome for smaller companies. The process includes updating company records and amending shareholder communications. It may also require reissuing share certificates. Each of these tasks has associated legal and administrative fees. These costs can strain the resources of smaller firms. Additionally, educating shareholders about the split can lead to further expenses. This education is necessary to minimize confusion. Such costs can impact the company's financial performance. If the expected benefits, like increased investor interest or trading volume, do not materialize, the split may not be beneficial. For smaller companies with limited budgets, the costs may outweigh any potential advantages. This situation can adversely affect the company’s operations and growth plans.

Compare Online Brokerage Accounts

Has a stock split made a company’s shares more accessible to you? Before you can buy and sell shares of stock, you’ll need to open a brokerage account. Benzinga offers insights and reviews on the following brokerage account providers. If you don’t already have a place to buy and sell, consider beginning your search with a few of the links below. 

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