Stock Splits: What You Need To Know

Have you ever thought that the price of a stock was too high and then, the first thing you know, the stock price has dropped by 50%? In many instances, the reduction in the stock price occurs because of a stock split. Here’s all you need to know about such an activity. 

What is a Stock Split?

Increasing the number of shares that are outstanding and simultaneously reducing the stock price is called a stock split. That can come with a 2-for1 split, a 3-for-1 split, or even more, and, in doing so, the stock price would decrease by the same ratio.

Why Do Companies Engage In Stock Splits?

1. To attract more buyers

   • Potential investors might perceive that the current stock price is too high and not be inclined to buy the stock as a result. Splitting the stock would bring down the share price to a level that would attract such reluctant investors as many investors believe there is more upside to a stock when the price is lower.
2. To increase the volume of shares that are traded to increase the liquidity of the shares.

Does a Stock Split Adversely Affect One’s Investment?

A stock split has no effect on the value of the shares that you hold in your portfolio.

What Happens When a Stock Split Occurs?

Nothing happens directly in the event of a stock split but, according to studies, performed in 1996 and in 2003, by David Ikenberry, Chairman of the Finance Department at the University of Illinois at Urbana-Champaign, historically,

• The price of a stock outperformed the broader market by 8% during the year following the split, and,
• By 12% in the 3 years that follow such a split

Reverse Stock Splits

Reverse stock splits:

• Increase the price of the share and reduce the total volume of the shares that are outstanding. This is usually done to reduce the chance that the share price will fall below the $1 minimum price per share (for 30 consecutive days) required by the stock exchange where it is listed and be delisted although, under certain circumstances, the stock exchange can suspend its minimum price requirement.
• Usually are telling you that something is wrong when the share price of a company cannot remain above the exchange’s minimum listing price but not all reverse stock split strategies signal that there is something wrong and caution is advised when considering this type of investment.

What Is a Reverse/Forward Stock Split?

A reverse/forward stock split is a strategy:

• Designed to eliminate shareholders who do not own the required number of shares to participate in a split thereby reducing administrative costs related to providing outstanding shareholders who might require documents such as voting proxies and
• Used by a company to force investors to purchase more shares at a lower price to participate in a forward split. For example
  • Were a company to announce a forward 2-1 stock split for investors who hold at least 50 shares and you only hold 45 shares you would not qualify for the split and would either be forced to cash out before the split or purchase an additional 5 shares to push your holdings up to 50 shares.

Editor’s Note: Material for this article was sourced primarily from an excellent but lengthy and detailed article by Ross Cameron of warriortrading.com.