Stock Splits

Updated on January 4, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Stock Splits Meaning

Stock splits refer to the process whereby a company increases its number of shares, reducing the per-share price of the stocks. The splitting is done following a significant rise in stock prices, making it difficult for investors to spend on them. However, reducing the costs makes purchasing the company’s shares easier for traders, and they can continue choosing them for trade despite their rising value.

Stock Splits

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Though the shares split up, the total price of the stocks is the same when the price per share is added. Thus, an existing investor’s pre-split price of stocks will remain the same post-split with an increased number of units.

Key Takeaways

  • Stock splits are a process whereby a company increases the quantity of shares to reduce their prices, making them more accessible to retail investors.
  • The publicly traded companies decide on splitting stocks in consultation with the board of directors.
  • Forward and reverse splits are two broadly classified categories of stock splits.
  • When companies split stocks, it indicates their positive growth and progress, leading to decreased share prices building an investor base as shares become more accessible.

Stock Splits Explained

Stock splits are a decision a company takes in consultation with its board of directorsBoard Of DirectorsBoard of Directors (BOD) refers to a corporate body comprising a group of elected people who represent the interest of a company’s stockholders. The board forms the top layer of the hierarchy and focuses on ensuring that the company efficiently achieves its goals. read more. The companies that make their shares publicly available to investors keep a particular number of units outstanding. They increase the outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet.read more, reducing the per-share amount for traders. Though the companies split the shares for a reason, they ensure the existing shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares.read more receive more units equalling their invested amount.

Stock splits reasons

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Primarily, companies announce a split when a long run-up is observed in their share prices. The share splits, as the process is also known, reduce the share price to make it affordable for retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more. This, in turn, increases the investor base of the firms. Furthermore, the investors’ trust in the company impacts the share prices positively, and the increase in the quantity of shares leads to their improved liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more. This enhancement in liquidity makes the market more efficient, lowering the bid-ask spreadBid-ask SpreadThe asking price is the lowest price at which a prospective seller will sell the security. The bid price, on the other hand, is the highest price a prospective buyer is willing to pay for a security, and the bid-ask spread is the difference between them.read more.

For interested retail investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more, shares become more accessible, while splits do not change anything for the existing shareholders except increased number of shares. On the contrary, future Earning Per Share (EPS)Earning Per Share (EPS)Earnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more might reduce as the number of shares increases. In addition, share splits are tax neutral. There is no flow of money during share splits; hence there are no tax implications.

As the stocks split due to the rising prices of a company’s share, the market players are aware of the firm’s excellent performance. As a result, investors believe that the performance will continue to be better, and the company will remain in profits for the upcoming years. This, in turn, enhances the demand of the stocks and the prices simultaneously.

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Types

Stock splits occur in particular forms. Hence, they are classified based on those patterns, which fall under two broad categories – Forward/traditional/conventional and Reverse stock splits.

Stock Splits Types

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#1 – Forward Splits

Such splits are traditional and the most common types of share split. Here, a company increases the quantity of shares, thereby reducing the prices to a multiple that equals the unit share price. For example, Company A performs well, and its stock prices go up to $1000, making them unaffordable for an average retail investor. Then, to build its investor base, the firm splits the stocks into two and starts selling them at a reduced price, i.e., $500, to make them more accessible to traders.

The most commonly found forward split patterns are 2-for-1, 3-for-1, and 3-for-2. For example, in a 2-for-1 stock split, the investors receive two shares post-split for each share they owned before the split occurred. Similarly, for the rest two patterns, shareholders get three shares for every share and every two shares, respectively, after the split.

#2 – Reverse Splits

It is the opposite of a forward share split. In this case, companies reduce the volume of shares to increase the unit share price. They do this to secure their place in the market. The stock exchange that lists such companies’ stocks delistsDelistsDelisting is the process of removing a security from a stock exchange so that it can no longer be traded on that market. It can occur for a variety of reasons, including non-compliance with listing rules or norms, mergers, or bankruptcy.read more them when their stock prices decrease beyond limits. Thus, these firms opt for reverse splits to retain their market position.

For example, if Company X reaches a point where its 100 shares trade at $50, it can opt for a 1-for-2 reverse split. The process can reduce the amount of shares to 50, and shareholders would receive one share for every two shares they own, increasing the prices to $100 per share.

Examples

Let us consider the following stock splits of 2021 and 2020 to understand how the principle works:

#1 – Stock Splits Nvidia

In July 2021, Nvidia split the stocks with no real long-term economic advantage in mind. It split the units in an unusual pattern, i.e., 4:1, different from the most widely adopted 2-for-1 pattern. It indicated one investor would own four shares post-split. This imposed a short-term bullish effect on the market. In addition, it made the NVDA stocks much more accessible to small retail investors as the prices reduced significantly.

#2 – Stock Splits Apple

Apple has split stocks, with the most recent one recorded in August 2020. It was the fifth time it split stock since 1980 as 4-for-1, offering four shares to shareholders for every share they owned. The shares were worth $499.23 each before the split, and post-split, it was reduced to $127. In June 2014, the tech giant split stock as 7-for-1, which reduced post-split price to $93 per share from $650 per share pre-split. However, the tech giant is soon set for more upcoming stock splits.

Stock Splits vs Bonus Issue

A bonus issue is similar to forward splits as both the terms involve an increase in the volume of shares and a decrease in the prices. In addition, these terms indicate how well the company is performing in the market. For example, when a company distributes shares from its reserves, it shows the positive financial health of that firm. Moreover, a share split occurs when its stock prices rise, indicating its strong market presence.

In case of a bonus issue, a company offers additional shares to existing investors without issuing dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more. Instead, the companies distribute these extra shares from the free reserves. On the contrary, a share split refers to splitting the existing company’s shares.

So far as the pricing for the bonus issue is concerned, the face value of the shares is equal. In addition, the existing shareholders receive the shares as extra and free of cost. However, the stock splits lead to the reduction of face value in the same ratio.

Frequently Asked Questions (FAQs)

What are stock splits?

Stock splits refer to the technique using which companies increase the volume of shares to reduce share prices, making it affordable to interested investors without changing anything for the existing shareholders except for their volume of shares.

The share splits can either be a forward split or reverse split. While the forward split marks the increase in the volume of shares and decrease in their prices, the latter indicates a reduction in the quantity of shares and an increase in their prices.

Why do stock splits?

The stocks split when the current stock price makes the units inaccessible and unaffordable for investors. The division is so made that the ratio is kept the same, and each share is priced equally to make the shares affordable for small and big retail investors. It also enhances their liquidity with high shares, creating a more efficient market and lowering the low bid-ask spread.

What happens when stock splits?

When stocks split:

• Enhances market capitalization
• Increases stock liquidity
• Displays company’s confidence in stocks
• Makes stock purchases affordable for even smaller investors
• Indicates the stronger market position of a firm

Stock Splits Video

 

This article is a guide to Stock Splits, its meaning & types. Here we explain how stock splits work and what happens when it occurs using examples from 2020-2021. You may also have a look at the following articles on Corporate Finance –

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