Let’s compare stock splits to slices of pizza for a sec. Let’s say you have a whole pizza. You split the pizza into 6 slices. But you realize it is an extra-large pizza, so dividing it into so few slices means each one is huge. Therefore, you decide it’ll be better to cut it into 12 slices instead, which means you cut each slice into 2. What’s happening here is a 2-for-1 split; each of your slices now becomes 2. Notice that the total quantity of the pizza (the analogy being a company’s market cap) did not change, but the number of slices (stock shares) has doubled. Because each slice (stock share) is now half the size, the value of each slice (stock share) has also decreased by 50%.
Now, let’s come back to the world of the stock market. In investing, more units of stocks don’t always mean more money. And a small amount of money doesn’t always mean you have lesser units of stocks. It all depends on the price of an individual stock. I’m sure by now, you understand that the price of a stock changes but the total value in your portfolio remains the same when stock splits occur.
Before the company’s Board of Directors approves the stock split, they will first have to decide on the distribution rate, or ratio for the stock split. It can be 2:1, 3:1, 4:1, so on and so forth. Majority of stock splits are 2-for-1. This means that for every one share you own, you will receive two shares after a stock split.
Let’s say you had 10 shares of Netflix in your investment portfolio before the stock split on July 2, 2015. Each share was priced at about $700 before the split. Therefore, the value of your shares was $7,000. Then a stock split was approved by the Board of Directors of Netflix to the ratio of 7:1. Once the stock split completed, your 10 shares became 70 shares. The unit price of each of your shares became $100. While the total value in your portfolio allocated to Netflix shares remained at $7,000. In a nutshell, this scenario shows that with a stock split your number of shares increased, the price per share decreased, but the market value of your total Netflix shares remained the same.
Netflix had approximately 60 million shares outstanding before the split. After the 7:1 stock split, the number of shares outstanding have increased by a factor of 7. Therefore, the number of shares in the stock market increased to about 420 million.
Now the question is why would corporations declare stock splits? Here are some reasons.
- The company’s Board of Directors wants to reduce its share price, thereby making their shares more affordable for those with a limited budget. This is actually the general motivation for companies to undergo stock splits- to make their stock more affordable and easier for investors to buy.
- The company wishes to increase their liquidity. Where there is an increase in liquidity, more buyers and sellers trade their stocks. When trading on their stock is more active, then they have the potential of increasing their capital if the corporation decides to issue more shares in the future.
- Companies would opt for a stock split when they see that their share price has increased significantly higher than their peer companies. Of course, they want their stocks to be competitive in the market.
- This next point is relevant to reverse stock splits. If a corporation’s stock price goes below a certain threshold, it will be delisted from certain exchanged and indexes. Companies want to avoid that so they issue reverse splits. We’ll discuss this further in the next section.
Basically, a corporation announces a stock split to increase their marketability and liquidity. The more marketable they are, then the more people will invest in their stocks. As a result, the company increases its market value.
Now that you have a clearer understanding about a stock split, what then is a reverse stock split?
From the word “reverse”, a company decreases (instead of increases) their number of shares in the stock market by combining current shares of stocks into fewer ones. For example, if a corporation announces a 1:2 reverse stock split, then two shares of stock are combined into one share of stock. Rather than reducing the share price, this process boosts the price of each share. A company has to pull off a reverse stock split when their share prices are lowered to pennies or a few dollars. That is just an unattractive impression to their current and potential investors. When a price share of a stock is below a certain level, they will be delisted from an exchange or removed from a stock index. This is when there’s a need for a reverse stock split.
To illustrate, let’s say Company X has 1,000,000 shares of stocks at $100 each. So the market cap value of their stocks is at $100 million. Then they announce a 1-for-2 reverse stock split. Company X will now have 500,000 shares of stocks with a higher price per share of $200. The number of shares decreases, the price per share increases, but the market cap value is still the same at $100 million.
When its stock price went below $2, financial giant American International Group actually had a 1-for-20 reverse split in 2009 because they were in danger of being removed from the New York Stock Exchange. The move decreased the number of shares outstanding by a factor of 20 but boosted their stock price to over $20 per share.
So, if while reviewing your portfolio you notice that your number of shares suddenly increased but the price per share decreased- relax and do not panic. Perhaps you just missed the company’s announcement of a stock split. Money Today magazine has an analysis of the top 30 companies that underwent stock splits from January 2001 to May 2010. The analysis showed that half of these companies got positive returns during a one year period from the stock split date. The rest however, had negative returns.
As for reverse stock splits in general, it is not a good indication of a company’s marketability. It basically means that the stock price is in trouble.
In either case, education is a key, being proactive is crucial, and deciding what to do next based on emotions is unnecessary. Investors must educate themselves about a company’s standing even further before taking any action after stock splits.