What is a stock split? A stock split occurs when a company decides to break its existing shares into multiple shares. Another term for this is forward split. A company may split stock if they wish to increase the number of shares and can be done by issuing additional shares to their current shareholders. Though the number of shares is higher, the total price of the shares won’t change. Therefore, a company will not gain value from splitting their stock. Below is a guide to help you understand everything you need to know about stock splitting and how it can benefit you. You will learn:
- How stocks split
- Why stocks split
- What a reverse split is
- Why a company would decide to reverse its shares
- How stock splits affect investors
- If stock splits affect short-sellers
- Tips for handling stocks splits
- How you can benefit from a stock split
How Do Stocks Split?
When a company is publicly traded, it will have a specific number of outstanding shares that have been both issued and purchased by investors. When a company decides to do a split to increase its outstanding shares, it can decide on the ratio it wishes to split by. You will typically see ratios of 2-for-1, 3-for-1, or 3-for-2. Though any combination that they choose is possible.
An example of a stock split would be a company choosing a 2-for-1 ratio for their split, and you held 200 shares of stock with the company, that was valued at $400. After the division, you would own 400 shares that still had the same total value of $400.
Why Do Stocks Split?
Companies may choose to split their stock for a number of reasons. One instance where a stock split may be a good option for a company is if they see the share price increase to a point where certain stock investors are priced out. They will then split the stock to make it both affordable and accessible to a wider range of investors. This is typically done when the price of shares has risen to a significantly higher price than other competitive companies in the industry.
Another possible reason for a split can be perceived liquidity. When the share prices are more affordable, they may be considered more attractive to investors as they may see them as easier to liquidate when needed. This can make the investment less risky. It also shows investors that the company is growing, which can make it an even more attractive investment.
The final reason that a company may decide to split their stock is in an attempt to cause their stock prices to rise. If share prices are more affordable, more stock will be bought, increasing the demand. A rise in demand can often lead to an increase in price.
What is a Reverse Stock Split?
The opposite of a forward stock split is a reverse stock split. While the forward stock split will increase the shares of a company, a reverse split has the opposite effect. This means that the number of shares of stocks will decrease, which will cause the individual share price to increase.
Why Would a Company Decide to Reverse its Shares?
Even though reverse stock splits can increase the share value of the stock, it is never considered good news for an investor. A company is most likely to engage in a reverse stock split when they are close to being delisted, which can happen when their per-share price drops below a specific price per share. Since they don’t meet the minimum price requirements, the reverse split can raise the value enough to allow them to remain listed.
It also can make them look more respectable when other players in their market are boasting higher share prices. If the price of a stock drops too low, many investors may be questioning why their prices are so low compared to others in the industry.
Another reason that a company may decide to reverse split their stock is to be able to jump from listing as a penny stock to a stock that has a listing on the larger exchanges. By making this move, they not only reach a larger audience but also attract more investors.
How Are Stock Splits Good for Investors?
You may be wondering if a stock split could be useful for investors. Stock splits can be good for investors for many reasons. First, it is often an indication that the company is growing and could turn out to be a good investment. You will also gain more liquidity, which makes it easier to unload or move.
Stock splits can be ideal for investors if they have the right amount of stock when it occurs. Too few shares can mean the price moves so quickly that a run can easily be killed. Too many shares can also be problematic as the total value of your stock may not increase a lot over a given period of time.
Another advantage for investors looking for more accessibility is that the shares are more affordable. For example, a stock with a value of $500 per share may make it inaccessible to many investors as $5,000 will only get you ten shares. But if it has a 5-for-1 stock split, you would be able to own 100 shares for the $5,000. If you currently have stock with the company, it will allow you to achieve a larger position.
Do Stock Splits Affect Short Sellers?
When you short sell, you are essentially betting against the stock, hoping to make a profit after the stock’s value begins to decline. At first glance, it may appear that a stock split is ideal for a short seller. After a 2-for-1 stock split, you could buy back the shares that you just sold for half the price. Simple as that — unfortunately, that is not the case. The price after a stock split is adjusted, meaning that you would be responsible for the same dollar amount.
Stock splits will not provide any advantage for a short seller, but it does not really affect them in any type of material way. The biggest change that they will face is the number of shares being shorted and the price per share.
Tips for Handling Stock Splits
While you can gain valuable advice from others, you will also need to do research yourself to determine how best to handle a stock split. You need to be wary of a number of schemes perpetrated by promoters pushing you to take advantage of stock splits.
While some of this advice may be valid, others may be ploys often referred to as a “dump and dilute.” In a dump-and-dilute scheme, a company will issue a large number of shares of stock, with no catalyst behind it. When this occurs, the value of the share prices drops catastrophically, becoming almost worthless to the current shareholders. Once the float has increased enough to a level that can no longer be maintained, then a reverse split will occur. This cycle is usually ongoing and basically prevents investors from making money off of their investment.
How Can You Benefit From a Stock Split?
Investors can find opportunities in almost any occurrence, and stock splits are no different. There are many ways that stock splits can be advantageous to investors and by understanding stock splits and learning how to play them in your favor, you can increase your portfolio and grow your bottom line.
Generally speaking, both forward and stock splits will not be profitable in themselves, but they can be useful indicators that can help you predict whether a stock split is a sign of good things to come and whether investing more might be a profitable option. It can also be a good indication that a stock is not performing as it should, and it may be time to get out of your investment.
Typically when a forward stock split occurs, it is considered a sign that the stock is at the beginning of an upward trend, and you can take advantage of the lower per-share price to gain a larger portion of the company and increase your profits from it.
On the opposite side of the spectrum, you can often see a reverse split as a sign of a company in trouble. This can be the case if the company is reverse splitting to avoid being delisted, but can also be seen as an advantage if the act is to move the stock from penny stocks into a larger exchange listing. A reverse stock split, for this purpose, will likely attract more investor and increase its overall value.
In either case, the key is doing your research and combining these indications with other indicators to see whether or not the company is splitting the stock to increase its growth or to simply stave off disaster.
While stock splitting itself will not change the value of the shares that you currently own, it can provide you with opportunities as well as prime indicators as to how the stock may perform in the near future. To take advantage of these opportunities, you will need to know what to look for and understand the process of stock splitting and its ultimate goal. Want to learn more about how to sway a stock split in your favor? Sign up for our webinar or download our free e-book today.