What is a stock split?
A stock split or stock divide is a way of increasing the outstanding number of shares in a company. It works by dividing the number of existing shares of a company into multiple shares. The most common split ratios are 2-for-1 and 3-for-1. This means that a stockholder would have 2 or 3 shares, depending on the type of stock split, for every share held before the split is issued. The number of shares originally held may be divided into a larger number, but the total value of all the shares remains the same as the original value.
How is a stock split issued?
Let’s say hypothetical company ABC has 10 million outstanding shares that are currently trading at $50 per share. Overall, this gives company ABC a market capitalization of $500 million. The board of directors agreed to issue a 2-for-1 stock split by the first week of September. This means that all investors who own a share of company ABC would receive an additional share for each one they have.
After the split, the outstanding number of shares of Company ABC would become 20 million. Despite increasing the number of shares, the company’s market capitalization still remains at $500 million. This is because as the number of shares is multiplied, the price for each share is also divided into 2. After the stock split, each share of company ABC is now valued at $25 each.
Why do companies undergo a stock split?
There are 2 common reasons why companies issue a stock split. First, a it can result in a more affordable stock price because it divides the original stock price into 2 or 3. Stock splits are done by companies whose stocks reached a very high value. Thus, they opt to stock splits to make them more affordable to investors.
Second, a stock split can also contribute to a higher liquidity. Stocks that are valued too high can have lower liquidity because some investors could not afford such high prices. A higher liquidity can also result to a tighter bid and ask spread, which goes in favor for both the company and the investors.
Stockholders who invested before the stock split can also benefit greatly from it. Based on historical data, most companies that underwent stock splits has exceeded the price level at which they previously issued the split. Because of this, companies may undergo several stock splits afterwards. Which would also result to a multiply of profits for long term investors.
Reverse stock split
The opposite of a forward stock split is called a reverse stock split. It is issued by companies with very low stock prices, often going below $1, to avoid getting delisted from the market. It works by merging several shares into a single share, in an attempt to increase the price for each. For example, a 1-for 10 reverse split which is originally priced at $0.50 each can become $5 after the split. A reverse stock split may also be issued in an effort to reduce the stock’s volatility and discourage spectator trading.
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