Understanding the 2-for-1 Stock Split

A t any given time, any publicly traded company has a finite number of shares outstanding. A stock split is a tool that companies can use to increase their number of outstanding shares, and a 2-for-1 stock split is one of the most common types. While it’s easy to think that more is always better, the reasoning behind stock splits gets a little more complex.

Key Takeaways:

  • A stock split is a corporate action that increases the number of a company’s outstanding shares by dividing up each single share into multiple shares.
  • A 2-for-1 stock split doubles the number of shares any one shareholder owns while dividing the stock price in half.
  • While there is some practical rationale behind stock splits, such as increasing liquidity, investors should be wary of investing based only on a stock split action. The split doesn’t change any underlying business fundamentals.

What Is a 2-for-1 Stock Split?

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A stock split is a corporate action that the board of directors at a company can take. All companies that are publicly traded have a set number of outstanding shares. The stock split action increases the number of outstanding shares by dividing each share into multiple shares, which decreases the stock’s price.

Companies can split stocks in a few different ways, including 3-for-1, 3-for-2, and 5-for-1 stock splits, but a 2-for-1 stock split is one of the most common types. When a company chooses to take this particular action, the number of shares doubles and the stock share price gets cut in half.

When stock prices increase, it has both positive and negative effects on the company. A price increase can indicate a vote of confidence, but new investors may have a harder time purchasing blocks of shares if prices go too high. As a result, companies may decide to issue 2-for-1 stock splits to make shares more affordable.

A stock split doesn’t affect a company’s market capitalization. That figure will stay the same. Think of it this way: If you exchange a $100 bill for two $50 bills, you still end up with $100 total. So, when a company does a 2-for-1 stock split, each stockholder ends up getting an additional share for every share that they hold — but each share’s value is cut in half. In other words, a pair of shares is equal to the original value of one pre-split share.

A Real-World Example of a 2-for-1 Stock Split

In April 2015, Starbucks (NASDAQ: SBUX) did a 2-for-1 stock split. It was the ubiquitous coffee brand’s sixth stock split as a publicly traded company. The rationale was to increase liquidity and offer a more attractive share price. The move cut the share price for Starbucks from around $95 to about $48.

How Does a 2-for-1 Stock Split Work?

In general, a company’s management team and board of directors want to maximize value for their shareholders. If they think that the price of one stock share is getting too expensive, they may choose to do a 2-for-1 stock split so that smaller investors can continue to invest in their stocks. If the price of a share is so high that it prevents smaller investors from purchasing stock, it will limit the number of investors, which may restrict the stock’s upside price potential.

Let’s say you have stock that is currently sold at $150 per share, and the company issues a 2:1 stock split. You (and every other shareholder) would now own two shares for every one share you had owned previously, but for $75 per share. If you previously had 10 shares for $1,500 in total value, you’ll now have 20 shares for that same value. You keep the same total value you had before, but now the shares may be more accessible for a bigger number of potential investors.

When a company does any kind of stock split, they will announce their intention to do the split and indicate that the change applies to shareholders as of a given date. Shortly after that set date, shareholders receive their additional shares.

What Is a Reverse Stock Split?

Companies can also do what’s known as a reverse stock split, which basically works in the opposite way as a traditional stock split. With reverse stock splits, companies reduce the number of outstanding shares, causing the price to rise. In a 1:2 reverse stock split, if you have 10 shares at $150 per share, you’ll end up owning 5 shares worth $300 per share.

Companies may choose to do reverse splits to gain respectability by having a higher share price, or they may do it to prevent their stock from getting delisted because the share price is too low.

Why Would a Company Do a 2-for-1 Stock Split?

A stock split has a few main advantages for the company making that move. Companies may choose to do a stock split for one of the following reasons:

  • Increasing the liquidity of a stock: Companies may feel that reducing their stock price will increase the stock’s liquidity because the split makes the stock more affordable to smaller investors. The theory behind the move is that investors will become more likely to buy the lower-priced shares after the stock split, thereby increasing the trading volume of the stock and its overall liquidity.
  • Increasing the stock price: Sometimes, a stock split leads to the stock price increasing after the initial decline in price. This happens when shares become more affordable to investors. When investors buy more of the stock, it may drive the price up again.
  • Boosting investor perception: Investors may take a stock split as a positive sign that share prices have increased. Investors may perceive that the split offers value by making the stock price more accessible. This may also motivate investors to buy more shares after the split, which may again boost share price and the stock’s overall value.

Stock splits often offer another perk for investors: They make it easier to re-balance portfolios. Because each trade now requires a small percentage of an investor’s portfolio, it becomes easier to sell shares to buy new ones.

Drawbacks of Stock Splits

Stock splits also come with some disadvantages. Beginner investors need to be careful because a stock split isn’t always a good thing. When a company does well, a stock split is almost inevitable with growing book value and dividends. However, this can lead to the false perception that stock splits mean automatic benefits.

Volatility Can Increase…

Stock splits have the potential to increase volatility in the market due to the changing share price. When more investors decide to purchase stock that’s now more affordable, the stock’s volatility can rise, which can make it a riskier investment.

…While Share Price Doesn’t Always Increase

Sometimes, companies have to do a stock split because they’re in danger of having their stock delisted. Reverse stock splits may often lead to the per-share price going up right after the split, but it may take some time for the company to recover. It’s possible that the stock may not grow in worth at all following the split. New investors run the risk of losing money if they don’t know the differences between stock split types and the reasoning behind them.

Stock Split Psychology

T hough stock splits may have some tangible potential effects (like increasing liquidity), companies often choose to make this move due to the psychology behind it. Companies may worry that as their stock price rises, investors may think the price is too high, and smaller investors may feel that it’s completely unaffordable.

A stock split pushes down the stock price to a level that many investors deem more attractive. The stock’s actual value doesn’t change at all, but the lower price can entice new investors while making existing shareholders feel like they have more shares than before.

For the most part, stock splits don’t really align with financial theory, but companies still take this action constantly. Stock splits are a good example of how investor behavior and corporate action don’t always fit in with financial theory.

This also offers a good reminder that a stock split shouldn’t be the only reason you choose to buy stock in a company. A stock split has no impact on a company’s worth because it is measured by its market cap. While there are psychological and practical reasons why companies choose to split their stock, the action doesn’t change their business fundamentals. In fact, it doesn’t change anything at the company level. Whether you have 10 shares priced at $150 per share or 20 shares priced at $75 per share, you still have $1,500 in stock.

There’s mixed evidence when it comes to stock splits. Sometimes, a stock split can help create a short-term rally in share prices, and some people believe that those results are at least partly due to the increased liquidity.

All in all, if you think of earnings like a cake or pie, stock splits only increase the number of slices you get. They don’t make that cake or pie any bigger. Splits can lead to temporary gains for investors, but they’re typically best viewed as one-off events that won’t automatically improve (or diminish) a company’s underlying quality.

Since the 2-for-1 stock split is one of the most common types of stock splits, you’ll likely come across this action when you’re investing. Understanding what this move means for a company can help you plan out your next investment move.