Stock Split

By Fool.com

All companies that are publicly traded have a certain number of shares outstanding, or stock shares that have been issued and purchased by investors. When a company decides to split its stock, it increases its number of shares outstanding by issuing additional shares to its current shareholders.

When a company splits its stock, it can decide on the split ratio. The most commonly seen stock split ratios are 2-for-1, 3-for-1, and 3-for-2, though other combinations are possible as well.

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How stock splits workLet's say a company decides to move forward with a 2-for-1 stock split. In this case, current shareholders would receive an additional share of stock for each one already held. If a company has 20 million shares outstanding and decides to enact a 2-for-1 stock split, it will wind up with 40 million shares after the split. The value of each share, however, will be reduced by 50%. Another way to think of it is that in a 2-for-1 stock split, the price of the shares changes so that every two shares equal the original value of a single share before the split. While a stock split will increase the total number of shares outstanding for a given company, it won't affect that company's market capitalization, which is the total market value of its shares outstanding.

Why companies split their stockThere are several reasons a company might choose to pursue a stock split. If a company has seen its share price increase to a point where investors are being priced out, it may opt to split its stock to make individual shares seem more affordable and accessible to investors. This strategy is particularly useful when share prices for a specific company have risen significantly more than those of similar companies within a given sector or industry.

Another reason a company might split its stock has to do with perceived liquidity. If a company's shares are seen as more affordable, investors may view them as more easily liquidated and therefore less risky. Additionally, a stock split can be indicative of growth for any given company, which is a positive sign for investors.

Finally, a stock split can actually cause stock prices to rise. Once a stock becomes more affordable and investors buy it up as a result, demand for that stock can increase. When this happens, the price of the stock can rise as a result.

Reverse stock splitsWhile a traditional stock split increases a company's total number of shares outstanding, a reverse split does the opposite. In a reverse stock split, the total number of shares is decreased, which causes the price of individual shares to go up. Reverse splits typically come into play when a company is at risk of being delisted for falling below a certain price per share, though some companies use reverse splits to portray themselves as more respectable players in the market by boasting higher share prices.

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