Stock Splits and Reverse Stock Splits
By Alex Dixon, YouCanTrade
All publicly traded companies have a certain number of shares they make available for the public to trade. Sometimes, that number of shares can increase due to a conventional stock split or decrease due to a reverse stock split. Neither stock split directly affects the overall value owned by shareholders, what is affected is how many shares you will hold after the stock split.
A stock split is where the number of shares increases by a certain ratio, the most popular being two-for-one. In a two-for-one stock split, every single share in existence owned by all the shareholders gets replaced by two shares at half the value. For example, if you own 1 share worth $100 and the company declares a two-for-one stock split, you now own 2 shares worth $50 each. The value of your ownership in the company, however, remains the same — $100.
A company’s board of directors may engage in a stock split for several reasons. The most common reasons are to decrease the stock’s price and increase liquidity. When a company’s share price becomes what the board considers “too high” or notably higher than similar companies in the same sector, decreasing the share price without changing the underlying valuation of the company is possible using a stock split. The less expensive shares seem more affordable to smaller investors and tend to attract more investors to the company. As the company attracts more investors and there are more shares available for exchange, the company’s liquidity increases. The increase in liquidity makes it easier to get in and out of a position and increases the availability of other products like options.
Due to this affordability to a larger pool of investors and the perceived notion of why stocks split, stock prices will often rise immediately following a stock split. However, there is no evidence stock splits affect the markets over time.
Two-for-one splits are the most common type of splits, but stocks are not always split two-for-one. How the stock is split depends on the company, and the company could declare a three-for-one, seven-for-one or ten-for-one stock split.
On the other hand, a company’s board of directors may decide it wants to increase the company’s stock price without changing the number of existing shares. A company can accomplish this with a reverse stock split.
A reverse stock split occurs when a lesser number of shares is issued for the number outstanding. A one-for-two stock split, for example, would cut in half the number of shares in existence but double the value per share. If you own 2 shares of stock worth $50 each and the company elects to do a one-for-two reverse stock split, you will have 1 share of stock worth $100. Because there are fewer shares outstanding after a reverse stock split and the prices of those shares has been increased, the share volatility and speculative trading of the stock often drop.
Companies may elect to do a reverse stock split to give the perception their price is at a certain point compared to similar companies in the same sector, to prevent the share value dropping too much or to avoid even becoming a penny stock. If a company’s stock price drops too low, a stock can be dropped by an exchange and become an over-the-counter stock. Companies can also come into certain regulatory problems if the stock price drops too low.
Like conventional stock splits, reverse stock splits can be done in ratios other than just one-for-two.
Companies use stock splits and reverse stock splits mostly for marketability and price management. Price and liquidity help companies reach their target investors and company objectives.
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