Stock Splits Explained: 3 Possible Consequences of a Stock Split

A stock split is a maneuver wherein a publicly traded corporation splits existing shares of stock into smaller, less valuable shares. In doing so, the company increases the number of shares available and lowers the stock price of a single share.

Investors that already hold the company's stock will not see the post-split value of their investment change. The total value of their shares at the new stock's price will remain the same. However, these stockholders will now own a greater number of shares with a lower market value per individual share.

A stock split lowers a company's share price without changing the overall valuation of the company. This is possible thanks to a split ratio that reduces the price of a single share by the same rate that it increases the total number of shares. The chief executive officer (CEO) or chief financial officer (CFO) typically proposes the exact stock split ratio. The company's board of directors then votes on the decision. Such a maneuver is common for companies on both the New York Stock Exchange and the NASDAQ.

A corporation’s board of directors can split stocks however they want, but there are some common split ratios.

1. 1. 2-for-1 split ratio: In a 2-for-1 stock split, each individual share of stock is split into two shares. The market price of those two new shares is one-half the price of the old share. For example, if a company used to sell shares for $100 apiece on the stock exchange, they would sell for $50 per share following a 2-for-1 split.
2. 2. 3-for-1 split ratio: In a 3-for-1 stock split, each individual share of stock is split into three shares. The market price of those three new shares is one-third the price of the old share.
3. 3. 5-for-1 split ratio: In a 5-for-1 stock split, each individual share of stock is split into five shares. The market price of those five new shares is one-fifth the price of the old share.

Other common split ratios include 8-for-1, 3-for-2, and 10-for-1.

As a corporate action, a stock split can have multiple downstream effects on a business.

1. 1. Heightened liquidity: When share prices are lower, it becomes easier for new investors to buy into the company. It also becomes easier for existing stockholders to purchase additional shares. When it is easy to pull money in and out of an investment, it is said to be liquid, and low-priced stocks have greater liquidity.
2. 2. Increase in company value: In some cases, a stock split leads to a greater market capitalization for a business because the reduced stock price makes the company more attainable for new investors. As more new people purchase stock and invest money in the company, the business's market cap rises.
3. 3. Greater volatility: One drawback to stock splits is that they tend to increase volatility. Many new investors may buy into the company seeking a short-term bargain, or they may be looking for a well-paying stock dividend. They may not show the same long-term commitment to the company that some institutional investors will show. The end effect is a rapid flurry of stock trading that can cause a company's stock price to ricochet up and down.

Investors may have stocks in their brokerage account that split without them realizing because a stock split doesn't change a company's market capitalization. This is particularly true for investors in mutual funds and exchange-traded funds (ETFs). Individual stocks within those funds may have split, but an unchanged market capitalization means the split is not always apparent.

A reverse stock split combines multiple lower-value stocks into a single stock that costs more money per share. This makes it the opposite of a traditional stock split, which is sometimes called a forward split. For example, in a 1-for-8 reverse stock split, every eight existing shares of stock get merged into a single share that costs eight times as much money to buy on the stock market. The company's market cap will not change and shareholders will neither gain nor lose money.

Businesses sometimes execute reverse stock splits to improve the prestige of their company. For instance, penny stocks can sometimes be more appealing to institutional investors if they are merged into stocks with a much higher share price.

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