Article

What is Stock Split and How do they Work?

date 26  September,  2023
time 4 mins read

Stock splits are like a financial magic trick that companies perform to make their shares more accessible to everyday investors.

Imagine you have a delicious pizza, and you want to share it with more friends. So, you cut each slice into smaller pieces. Stock splits work similarly, where companies divide their existing shares into more pieces, without changing the total pizza (company) size.

This makes each share more affordable and attractive to a broader group of investors. In this article, we’ll discuss stock splits, understand how they work, and explore why companies use this technique.

What is a Stock Split?

A stock split is a corporate strategy where a company boosts the number of its shares by reducing their face value. This is often done to enhance liquidity, as the stock price decreases post-split.

Although the number of shares increases due to the reduced face value, the overall investment value remains unchanged.

Shareholders typically receive their split shares within a week, making it easier for more investors to participate in the market and trade the company’s stock.

Types of Stock Split

Stock splits come in different types, each with its own implications for shareholders and the company’s stock structure. Here are the two main types of stock splits:

1. Forward Stock Split

A forward stock split is a strategy used to divide high-priced shares into multiple lower-priced shares, effectively reducing their price per share. This tactic is commonly employed for blue-chip stocks and serves various objectives, including making shares more affordable and increasing their accessibility to a broader range of investors.

2. Reverse Stock Split

A reverse stock split involves consolidating shares, reducing their number and increasing their price per unit. This strategy is uncommon but is employed during adverse market conditions when share prices continually decline. It safeguards a company from potential delisting on stock exchanges due to shares falling below required listing levels.

How Stock Splits Work?

Stock splits occur when a company divides its existing shares into multiple new ones, often lowering the share price.

For example, in a 2-for-1 split, each shareholder receives two shares for every one they owned before. This doesn’t change the total market value of their investment but increases liquidity and accessibility for investors.

The split can attract new buyers due to the lower share price, potentially boosting demand. Companies often implement splits to make their stock more affordable and encourage trading.

While the number of shares increases, the overall ownership stake remains unchanged, and historical prices are adjusted accordingly.

Advantages of a Stock Split

Stock splits have a few advantages for both companies and investors:

  • Increased Accessibility: High stock prices may make it too expensive for some investors to buy a single share. The share price drops after a stock split, making it more affordable for additional investors.
  • Boosted Liquidity: Stock splits increase the number of shares available in the market, which can enhance trading activity and liquidity. This can make it easier to buy and sell shares without significant price fluctuations.
  • Psychological Appeal: Lower share prices can attract more retail investors and may create a perception of affordability and value, potentially boosting demand for the stock.
  • Broader Ownership: Stock splits can encourage a diverse group of shareholders, promoting a broader ownership base and potentially reducing stock price volatility.
  • Positive Signal: Companies often use stock splits to signal confidence in their future prospects and financial stability. This can be seen as a positive sign by investors.
  • Options Contracts Adjustments: Stock splits can lead to adjustments in options contracts, allowing options traders to continue trading without significant disruptions.

In simple terms, stock splits make it easier for people to buy shares, increase trading activity, and may make the stock more appealing to investors, which can have positive effects on the company’s stock price and market perception.

Disadvantages of a Stock Split

  • Dilution: Stock splits increase the number of shares outstanding, diluting the ownership stake of existing shareholders.
  • Lower Dividend Per Share: As the number of shares increases, the dividend per share may decrease, potentially impacting income for income-seeking investors.
  • Reduced Perceived Value: Some investors associate a lower share price with a lower-quality company, potentially affecting the stock’s perceived value.
  • Options Contracts Adjustment: Options contracts may need adjustment after a split, leading to complexity and potential confusion for options traders.
  • Transaction Costs: Investors may incur transaction costs when buying or selling additional shares resulting from the split, potentially affecting overall returns.

The Effects of Stock Splits on Investors

Stock splits can affect investors in several ways:

  • More Shares: Investors receive more shares for each one they already own, but the total value remains the same.
  • Lower Price: The stock’s price per share decreases, making it more affordable for new investors.
  • Liquidity: With more shares available, it’s easier to buy and sell, increasing the stock’s liquidity.
  • Psychological Impact: Lower prices may attract more investors, potentially driving up demand and the stock’s value.
  • Historical Data: Past stock prices are adjusted to reflect the split, so it doesn’t affect overall investment value.

In summary, stock splits don’t change an investor’s total value but can make the stock more appealing and easier to trade.

Conclusion

Stock splits are like cutting a pizza into more slices, making it easier for more people to have a piece. They help companies and investors in different ways, like making shares more affordable or increasing trading activity.

But remember, they’re not always a guarantee of success, and it’s crucial to understand why a company is doing a stock split. So, if you’re thinking about investing, be sure to learn more and consider all the toppings on your investment pizza.

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