As a new investor, you may come across terms in news reports or public filings that you’re not familiar with and still don’t completely understand after looking it up. This article is part of DollarsAndSense’s investor education series, which introduces and explains investment-related terms.
Today, we answer the question: What is a stock split?
Definition of ‘Stock Split’
A stock split is a corporate action by a company’s board to increase the number of outstanding shares by splitting each share, which diminishes the price of the stock proportionally. This means that while shareholders own ‘more’ shares, their proportion of company ownership remains the same, and so does the company’s market capitalisation.
For example, in a 2-for-1 stock split, each original stock held by an investor will become two shares post-split, with each share is now worth half their original price.
Why Do Companies Perform Stock Splits
As mentioned earlier, stock splits do not change the equity owned by shareholders or the value of the company. However, stock splits do have some practical uses.
First, companies whose stock prices have surged over the years may find that when compared alongside other stocks on price alone, their stock might look too ‘expensive’ or appear overvalued. While this is a psychological effect, the fact that the markets can be driven by sentiment mean that appearances can have a material impact on investor interest.
Second, appearances aside, a lower stock price may arguably improve liquidity, since there might be a (slightly) larger pool of investors who are able and willing to buy. For example, Alphabet (which is Google’s holding company) is currently trading at around USD$1,000, while Microsoft’s share price is around USD$95. While there will be investors who can invest in denominations of $1,000, you can imagine there will be even more people who are only willing (or able) to put in a few hundred dollars into any one particular stock.
Thirdly, corporate actions like stock splits can generate increased investor interest, which may cause a (temporarily) bump in stock price. This is because stock splits are seen by some investors as a sign that a company’s stock price has been increasing, with an expectation that all things being equal, the positive trend should continue.
Reverse Stock Splits
A variation of stock splits is a reverse split. Basically, the reverse of a stock split happens: a reverse 3-for-1 split means that for every 3 shares that investors hold, they now only own 1 share post-split, but now trading a price that is 3 times more.
As with a regular stock split, the company’s market capitalisation and investor equity remain unchanged.
Companies may do reverse stock splits if their share price is really low, so that they look more presentable alongside competitors or other companies on the stock exchange. Also, companies may do a reverse stock split to avoid becoming delisted, which companies may be forced to do if their share price drops beyond a certain threshold.
What Do Stock Splits Mean For Investors?
It goes without saying, but a company’s stock price should not be the only indicator you use when deciding on your investments. While stock splits has no impact on the value of the company, one might want to take into account discount the increased investor interest that surrounds stock splits.
So now that you understand share buybacks better, what is another investing term you want us to cover next? Let us know on the DollarsAndSense Facebook Page!