What Is a Stock Split?

By Markets Fool.com

Publicly traded companies issue stock to raise capital for things such as research, product development, and expansion. During a stock split, a company will issue new shares to existing shareholders to increase the number of shares each one holds. Though a stock split can be a strategic move, it won't directly increase the value of the shares in question.

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How stock splits work

When a company decides to enact a stock split, it can choose the ratio it deems most beneficial. The most common stock split ratios are 2-for-1, 3-for-1, and 3-for-2, though technically any ratio is possible.

During a stock split, a company will increase its total number of shares outstanding, but in doing so, it will also lower the price of each individual share. Imagine that a company with 30 million shares outstanding opts for a 2-for-1 stock split. In this case, existing shareholders receive one additional share of stock for each share already held, and after the split, the company's total number of shares outstanding climbs to 60 million. However, the value of each share is cut in half as the result of the split. So if the price per share was $20 before the split, each share will be worth $10 after the split.

In this regard, stock splits serve a limited function. While a stock split will increase a company's total number of shares outstanding, it will not increase its market capitalization, which is the total market value of its shares. So if a company starts with 30 million shares outstanding at $20 per share, its market capitalization is $600 million. Splitting both the stock and its price in two results in the same total market value ($10 per share x 60 million shares = $600 million).

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Why companies like stock splits

There are different reasons for companies to split their stock. When a company's stock price goes up, that's usually seen as a good thing -- unless, of course, the price has gotten so high that investors can no longer afford to buy more of it. When this happens, a stock split can help a company lower the price of its individual shares of stock to attract more investors without actually taking a financial hit. Companies tend to employ this strategy when their share prices have climbed more rapidly than those of their competitors within the same industry.

A company might also split its stock to make its shares more liquid, which is another tactic for enticing investors. If a company's price per share is too high, buying that stock becomes a riskier prospect, because it's harder to unload shares that cost more money. If the price per share goes down, however, the shares can be more easily liquidated.

Though a stock split won't directly cause a company's stock price to rise, it can have this effect secondarily. The reason is that once a stock becomes more affordable and is perceived as less risky, demand for that stock can increase, and when that happens, its price can rise.

Reverse stock splits

While a traditional stock split increases a company's total number of shares outstanding, a reverse split has the opposite effect. During a reverse stock split, a company's total number of shares outstanding is reduced, which causes the price of each individual share to go up.

If a company's stock price falls below a certain point, it runs the risk of being delisted on major exchanges. By enacting a reverse stock split, a company can instantly increase its price per share and avoid this fate. Additionally, a company might opt for a reverse stock split to alter public perception. With a higher stock price, a company can more easily present itself as a respectable player in the market.

Just as traditional stock splits don't affect a company's market capitalization, so, too, do reverse splits have no impact on a company's total market value. Stock splits, in whatever form they happen to take, are really just a way of playing around with numbers in an attempt to change how investors view the stock and companies behind them.

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