What Are Stock Splits and Reverse Stock Splits?

Companies sell shares, called stocks, to investors as a way of raising money. If you own 1 stock out of the 100 that exist in a business, you own 1/100th of the company.

Large companies can have millions or billions of shares outstanding.

Now:

Sometimes, companies want to adjust the number of shares that exist without issuing more shares or buying shares back from investors.

To do this, they can use stock splits.

What is a Stock Split?

A stock split happens when a company decides to divide existing shares into multiple shares.

For example, a company with 100 shares might decide to double the number of shares to 200.

To do this, it splits every share in existence in two. Someone who owns one share now owns two shares, someone who owns five now owns ten.

Remember:

When a company splits its stock, it doesn’t change the value of the business itself.

Typically, the per-share price for a company will split by the same amount as the split in shares.

So, if every share becomes two shares, then the price of a share will halve. If one share becomes four shares, each new share will cost 25% as much as a share cost before the split.

An example

An example of a stock split was Apple in July 2020.

The company announced a 4-for-1 stock split, meaning that it would split each existing share in the company into four new shares.

This is the fifth time the company has split its stock since its founding.

The split will increase the number of shares that exist from 4.276 billion to 17.104 billion.

Every investor who owns shares in Apple will own four times as many shares after the split occurs at the end of trading on August 24th.

Why Do Companies Do a Stock Split?

There are a few reasons that companies split their stocks.

Keep shares affordable

One of the main reasons for splitting a stock is to keep shares affordable.

As a company grows, its shares naturally become more expensive.

Over time, the price of a share can rise too high for the average investor to be able to afford it.

Where someone might be able to easily afford a few shares in a company if those shares cost $50, it can be hard for someone to buy a single share in a company with a stock price of $500.

This has become less of an issue in recent years as more brokerages have let customers buy fractional shares in companies.

But, for those that can only buy shares in whole amounts, high share prices can make it difficult to buy shares.

Positive investor perception

Historically, stock splits have a positive investor perception.

Splitting a stock shows investors that a company is confident in its future performance to the point where it has to reduce its share price to keep shares affordable for investors.

In theory:

The value of a company does not change when it splits a stock, but historically, companies that go through a split tend to gain some value based on the news.

What is a Reverse Stock Split?

A reverse stock split is the opposite of a stock split, where a company reduces the number of shares that exist.

For example, a 1-for-2 reverse split takes two shares and combines them into one. Someone who owned 50 shares would then own 25 shares.

Depending on the reverse split, someone who does not own enough shares to receive a full share after a reverse split will either receive a fraction of a share or a payment equivalent to the fraction of the share they would have received.

An example

A recent example of a reverse stock split happened in April 2019.

A small biopharmaceutical company, Arca Biopharma Inc did a 1-for-18 split.

That means that the company combined every 18 shares in the company into one.

Why Do Companies Do a Reverse Stock Split?

Companies can do a reverse stock split for a few reasons.

Remain in an index or exchange

Many stock indices have requirements for stocks to be part of the index and many exchanges have requirements a company must meet before being listed on that exchange.

For example, the NASDAQ requires that a company’s share price be at least $3 for the stock to get listed on the NASDAQ.

If a company’s share price is falling, a reverse split can help increase the price of a share by reducing the number of shares that exist in the company. If a business is worth $100 and there are 100 shares, each share will cost one dollar. If the company does a 1-for-4 reverse split, the company should remain worth $100, but because there are fewer shares, each share will now cost $4.

If a business is worth $100 and there are 100 shares, each share will cost one dollar. If the company does a 1-for-4 reverse split, the company should remain worth $100, but because there are fewer shares, each share will now cost $4.

Avoid penny stock status and poor perception

Another reason to do a reverse split is that stocks with incredibly low share prices have a negative reputation among investors.

These stocks, called penny stocks, have a reputation for being incredibly volatile and risky.

The poor perception of penny stocks can cause investors to avoid a company, which can drive down its value even further.

However, reverse splits have a negative connotation as well, so many companies that go through a reverse split also lose investors and those investors lose confidence in the company.

What Do Stock Splits Mean for Investors?

Stock splits have a few implications for investors.

Impact on cost basis

One of the important things to record when you buy an investment is the cost basis, or how much you paid for the investment.

When you sell an investment, you report a gain or a loss based on the difference between the amount you sold it for and its cost basis.

When a stock split happens, you also have to adjust your cost basis.

For example, if you paid $50 for a share in a company and it goes through a 2-for-1 split, you will now own two shares, each with a cost basis of $25 (half of the original cost basis).

If the company goes through a 5-for-1, you’ll now own five shares, each with a cost basis of $10. You split the original cost basis between the shares owned after the stock split.

Impact on dividends

When a company pays dividends, it determines the amount each investor receives using the number of shares that each investor owns.

For example, a company might pay a dividend of $1 per share.

When a company splits its shares, it also splits its existing per-share dividend between the new shares.

If a company doubles the number of shares, it will typically halve its dividend per share.

Impact on future share prices

In theory, the number of shares that exist in a company should have no bearing on the actual worth of the business.

A company that’s worth $10 billion should be worth that much whether it has 10 million shares outstanding, 100 million, or 1 billion.

The only difference should be the per-share price as the worth of the business is divided amongst the shares.

In reality:

Both stock splits and reverse splits have a reputation with investors.

Splits tend to have a positive reputation, so companies often increase in value when they announce a stock split.

Conversely, reverse splits tend to have a negative reputation, which can lead to share prices dropping when a company announces a reverse split.

Understanding the reputation of different types of splits is useful for investors who want to predict how a split will affect share prices.

Conclusion

Stock split and reverse splits involve dividing or combining a company’s existing shares to leave a different number of shares than existed before.

Splits increase the number of shares, which tends to reduce the share price of a company while reverse splits increase share prices by reducing the number of shares that exist.

Companies undergo splits regularly for a variety of reasons.

Understanding what splits are, why they happen, and what they can mean for investors can help you understand what stock splits mean for your portfolio.