You may well have heard of a stock split, and perhaps even saw some claiming it’s a great way to make money. Spoiler alert: it’s not. But what is a stock split? Why do companies perform stock splits? Let’s explore and find out.
What is a Stock Split?
A stock split is an action of distributing new shares by a company to its shareholders.
The number of the company’s outstanding shares increases while the market capitalization (and the value of the company) remains unchanged.
There’s no money exchanged in that shareholders don’t pay for the new shares. They simply have more shares that are worth just as much as their previous (fewer) shares in total.
This is done in order to make it more affordable for an investor to buy the shares, and thus enable many people to own a share of the business.
Investors hope that with more people owning the company this way, the value of those shares will increase.
Stock Splits and Company Value
A stock split doesn’t change how much a company or its management makes. And it doesn’t change how much a company is worth, either.
It just makes it possible for lots of different investors to own small amounts of the business.
With more people owning stock, the likelihood that they will support the company’s management can also increase.
The lower price point also means there is greater liquidity of the stock, which in turn can mean greater stock trading volumes.
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If a company does a two-for-one split, it will double the number of shares outstanding.
Each existing shareholder will end up with twice as many shares after the split. Each individual share would be worth half as much as it was prior to the split.
A similar approach holds when a company does a three-for-one split or any other multiple for that matter.
Now that you know what is a stock split, let’s consider the motivations behind why companies use it.
Why Do Companies Split Stock?
Companies predominantly implement stock splits to make their stock more attractive for potential investors.
Consider shares of Berkshire Hathaway (Class A) which at the time of writing is trading at just over $430,000.
With $430,000 you could:
- buy a house in London
- buy a few houses in certain parts of the world
- travel the world many times over, luxuriously
- {insert your dreams and ambitions here}
The point is, there’s a lot you can do with $430,000 with buying shares in Berkshire Hathaway just being one of them.
Many people may not be able to afford to buy 1 share at that price.
But, suppose Berkshire Hathaway (Class A) shares are split in a 1,000-1 split. This would result in 1 share being worth approximately $430.
That makes the share far more affordable for many more people.
Now, a 1,000 for 1 split is unheard of.
For the most part, companies tend to implement 2 for 1, or 3 for 1 share splits. There are exceptions of course; Apple Inc. for example implemented a 7 for 1 split in the past.
But a 1,000 for 1 split would be very, very unlikely, almost impossible.
Incidentally, Berkshire Hathaway shares can be bought for a lot cheaper, via their Class B shares.
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What is a Reverse Stock Split?
A reverse stock split is like a regular stock split, but it is done in reverse. With a reverse split, each shareholder gets fewer shares than before and the price per share goes up.
Most companies don’t do reverse splits, but some do. Naturally, this bodes the question, why would a company perform a reverse stock split?
Well, a company might want to perform a reverse stock split if their stock price is too low, for example.
Consider a company whose stock trades at $0.80.
This would be a “penny stock”, and would raise suspicions amongst most rational investors almost automatically.
Implementing a 1 for 10 reverse stock split would result in the stock price increasing to $8.
Importantly, just like the case with a regular stock split, the value of the company and the market capitalization remain unchanged.
Thus, in this example, it doesn’t mean an investor has made a profit of $7.20 per share ($8 – $0.80). Their profit would be 0 since the value of their holdings would remain unchanged.
At a price point of $8, the stock’s liquidity will likely either remain the same or perhaps increase marginally.
This is because its transition from a “penny stock” to a “low dollar stock” may make it attractive to small investors / retail investors.
The increased demand from small investors could mean greater liquidity for the stock, for instance.
Okay, hopefully, you now know and understand what is a stock split. And you understand the rationale/motivation behind why companies split stock.
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