What is a Stock Split?

A stock split is when a company increases the number of its outstanding shares by splitting its current shares. This lowers the price of each stock and increases the stock’s liquidity on the market. For example, when a 2-for-1 split takes place, a shareholder who owns 10 shares, worth $50 each, has 20 shares, worth $25 each after the split. The best way to describe a stock split is that it’s the same pizza, just with more slices.

While a stock split does not change the value of a company or its stock, it is often seen as a bullish catalyst. Companies have different reasons for executing stock splits. Some would like to make the stock more accessible for retail investors by providing them with a lower share price. Other companies want to increase the liquidity in the stock.

Another possible reason for a stock split? Major corporations who wish to be included in a price-weighted index like the Dow Jones Industrial Average. Apple is one stock that underwent a stock split in the past, before being added to the Dow in 2015. Many believe the recent splits by Amazon and Google’s parent company, Alphabet may lead to their inclusion as well.

Stock Split Example

Let’s take a look at a couple of examples to clarify how stock splits work.

The recent splits by Alphabet and Amazon were by a ratio of 20 for 1. This means that for every 1 share of the stock, there will now be 20 new ones created. It also means that the stock price at the time of the split is divided by 20, to calculate the price of the new stock.

Let’s say for simplicity’s sake that these stocks closed right at $2,000 prior to the split. This means that the new trading price post-split would be $100 per share. If you owned 10 shares before the split, you now own 200 shares at the new split-adjusted price. But the value of your investment hasn’t changed.

Recall “the same pizza with more slices” example? Instead of 8 slices, the pizza now has 160 slices!

What is a Reverse Stock Split?

A reverse stock split is exactly as it sounds: the opposite of a traditional stock split. So rather than creating new shares, a reverse stock split actually consolidates multiple shares into a single share. Why would they do this? While normal stock splits are generally seen as neutral, reverse splits are typically a bearish event. A company could choose to do a reverse stock split to artificially raise the price of its shares.

Exchanges like the NASDAQ have a minimum trading price of $1.00 that stocks need to uphold or else they could be threatened with being delisted. If a stock is trading below $1.00 for some time, a company could do a reverse split to get the price back over $1.00. There are benefits to being listed on the NASDAQ compared to a smaller exchange like the OTC – Over the Counter – markets.

Share consolidation is another way of saying that the company has over-diluted the value of its stock by having too many outstanding shares. This is also a bearish sign for a company because businesses in financial distress will often sell stock to raise capital. If they continue to sell shares, then the stock becomes diluted.

Let’s take a look at an example of a reverse split.

Company XYZ is trading at $1.00 but is concerned that the price will dip below that price in the near term. It looks to undergo a 1-for-10 reverse stock split. This means that for every 10 shares there will now only be one. You can see immediately how this would have an impact on your investment position. The price of the underlying stock is now $10.00, and if you owned 100 shares before the split, you would now only own 10 shares of the company.

Stock Split vs Reverse Stock Split

As mentioned earlier, stock splits aren’t really bearish or bullish in nature. Reverse splits on the other hand send a sign that the company is under financial stress. While neither a split nor a reverse split changes the underlying value of the company directly, they can still have a short-term and long-term effect on the stock price.

Did you know that you can actually buy fractions of a stock? Gratis allows you to trade in fractional shares. So, even if the price of the stock of the company you want to invest in is too high for you, with Gratis you can buy its fractions. This is called fractional investing, allowing you to have an affordable slice from an expensive whole. So with Gratis, you can buy any stock on any investment budget. Neat!

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The value of an investment in stocks and shares can fall as well as rise so you may get back less than you invested. Past Performance is no guarantee for future results

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