There are numerous stock market concepts that investors and traders need to know about, and stock splits are one of them. Stock splits are quite common in the stock market with at least a few companies undergoing a stock split every year. That’s why it’s important to know what they are and how it affects investors and traders.
So, here is everything you need to know about stock splits.
A stock split is a company changing the total number of shares of the company.
When a stock split occurs, the total number of shares changes and the value of each share also changes, proportionately. For example, the number of shares will double while the value of each share will be halved if a 1:2 stock split occurs. This ensures that the total value of all shares remains the same. The stock split can be implemented for any ratio (3:1, 1:1.5, 1:3, 1:10, etc.).
A stock split occurs through corporate action and approval of the board of directors needs to be taken.
What are the types of stock splits?
There are two types of stock splits: forward splits and reverse splits.
The forward split decreases the value of each share while the reverse split increases the value of each share.
For example, in a forward split, one share is turned into three shares- each share being one-third of the original value. In a reverse split, three shares are turned into one share – with three times the original value.
Why do companies split stocks?
The reasons for entering into a forward split and a reverse split are opposite of each other.
Why enter into a forward split? A forward split lowers the total price of each share. This makes it easier for investors to invest in shares and increases the liquidity of the shares. A single share may be too prohibitively priced for investors if the share price has risen too much. So, the stock split makes shares of the company more affordable.
Why enter into a reverse split? A reverse split increases the total price of each share. A low price may reduce investor confidence in the company, and the company may also be delisted from the stock exchange. A reverse split increases the price of each share to reassure investors that the company is valuable.
Is stock split good or bad?
Generally, a forward stock split is seen as a good sign for the company. This is because the stock split is usually done when the stock price has risen too high indicating high demand in the market for their shares.
A reverse stock split can be seen as a bad sign for the company because it might mean that the share price has fallen too low and the company is taking corrective action.
However, there can be other factors at play which we’ll discuss.
Advantages of a stock split
A forward stock split has several advantages for both the investor and the company.
- More liquidity – A more liquid stock means that it is easier to buy or sell the stock. This makes the stock more attractive to both investors and traders. The fee charged for trading the stock can be reduced by higher liquidity which benefits traders. It also means that investors who may not have been able to invest in the company previously, can now invest in it since the price of the shares have lowered.
- Higher confidence – A forward stock split is usually seen as a sign that the company is doing well and has confidence in its future prospects. A company will usually not go through the large expense and hassle of splitting its shares if it is not confident that the stock split will create more opportunities for the company’s growth.
- Easier buybacks – A forward stock split can help the company buyback its own shares. The company’s action of buying back its shares will have a lesser effect on the stock price since the stock is more liquid after the stock split.
There is an advantage to reverse stock splits as well.
- Prevention of delisting – The reverse stock split can help a company remain listed on a stock exchange if a stock price is falling too low.
“Key Takeaways“
- ✔ A stock split changes the number of shares of a company and the price of each share proportionately.
- ✔ A stock split can be of two types: forward and reverse.
- ✔ A forward stock split is usually done so it increases the liquidity of the stock.
- ✔ A reverse stock split is usually done to avoid delisting.
Disadvantages of a stock split
While a forward stock split has many advantages, there are some disadvantages.
- Expensive and time-consuming – The process of splitting stock is quite expensive even for blue-chip companies. It involves a lot of very time-consuming paperwork by highly experienced lawyers and administrators which is expensive in terms of both time and money. The stock splitting process can also be tricky creating hassle for the company involved.
- Compliance challenges – There are many regulatory hurdles which need to be crossed and it is a long and cumbersome process.
- No benefit to market cap – A stock split does not actually change the company’s market capitalisation which is the total value of the outstanding shares of the company. This makes it seem like the company is undergoing such an expense for no benefit.
- Higher risk of delisting – A stock split may not always be warranted. If a company undergoes a stock split and then the share price of the company falls further due to market conditions, then the company can risk being delisted.
There are a few disadvantages of a reverse stock split as well.
- Lower investor confidence – A reverse stock split can signal to investors that the company is in trouble and they may jump ship. This is because a company usually does not enter into a reverse stock split unless the share price has gone too low.
Wrapping up
A stock split is an interesting way in which companies can manage their stocks. The stock split feature can benefit traders, investors, and the company.
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