What Is a Stock Split? A Complete Guide for Investors

A stock split is a strategic move by corporations where the total quantity of shares is increased by issuing additional units to existing shareholders. While the quantity of shares increases, there’s usually a corresponding decrease in price. This way, the overall market value or capitalization of the company’s shares remains the same. Companies take this step to make their shares cheaper without altering the value of your total investment.

Suppose you are a shareholder in a company; it becomes necessary to familiarize yourself with the concept of a stock split and act accordingly should that company take this move. However, when making such a decision, you need to understand why the company wants to stock split and how it can impact you as an investor. In this guide, we will walk you through everything you need to know about stock splits.

Why Do Companies Split Their Stock?

A study of 5,596 stock splits showed that firms achieved an average abnormal return of ~7% in the first year and around 12% over three years following the stock split announcement. This indicates that stock splitting rewards firms in the marketplace. Below are the five most common motivations:

1. To lower the cost of shares for individual investors

Stock can become very pricey as the business grows and its stock price appreciates, making it less appealing for small investors to invest in it. For retail investors looking to invest smaller sums of money, a stock price of $2,000 or $3,000 per share may seem too expensive.

By reducing the price per share while preserving the investment’s total value, a stock split can assist in resolving this problem. Therefore, making the stock available to a broader spectrum of investors, particularly those with less capital who might have previously felt priced out.

2. To Improve Liquidity and Trading Volume

Due to the lower price per share, a company’s stock price reduction makes it more accessible to a larger spectrum of investors, including institutional purchasers and retail traders. As a result, there is usually more trading activity in the stock, which improves its overall liquidity.

Both individual and institutional investors benefit from increased liquidity in a number of ways. First, it narrows the gap between the buying and selling prices of the stock by reducing the bid-ask spread.  And because trades can be completed more quickly without resulting in significant price swings, this lowers the cost of purchasing and selling shares. Also, the rate of executing orders is improved.

3. To Signal Confidence and Strong Market Outlook

Stock splits frequently happen after a business has seen steady growth and strong performance. A company’s decision to split its stock is usually interpreted as a sign of management’s confidence that the business will continue to grow in the future. It can reassure investors by showing that the leadership thinks the stock is doing well and expects future growth.

Consequently, a stock split announcement may boost investor confidence and encourage more people to purchase shares. This could result in a brief increase in the price of the stock. Moreover, as investors look to profit from the company’s ongoing expansion and success, the split’s optimism frequently drives the stock price even higher.

4. To Stay Competitive with Market Peers

Companies with high stock prices may find it more challenging to draw in retail investors in competitive industries when their rivals’ shares are more reasonably priced. By lowering its share price and making it more comparable to its competitors, a stock split helps such a company level the playing field. This can guarantee that the business doesn’t seem overpriced in comparison to its rivals, particularly if the stock price of the company is much higher.

For example, the share price of Nvidia rose to around $1,000, prompting the company to issue a 10:1 split in June 2024 in order to lower the share price to the current price range.

5. To Prepare for Index Inclusion

For businesses seeking inclusion in large stock indexes like the Dow Jones Industrial Average, stock splits can be a calculated move. Companies with very high share prices might not be eligible for inclusion in certain indexes due to their rules or preferences regarding stock prices. For instance, Dow Jones is price-weighted, and businesses with higher stock prices will have a greater impact on the index. This way, such a company could distort the overall balance of the index, making it less appealing for inclusion.

However, they can lower the price per share to a more reasonable level through stock splitting to increase their chances of inclusion in such indices. Given that many institutional funds and exchange-traded funds (ETFs) track index performance, this could lead to increased visibility among institutional investors and long-term demand for the stock.  Therefore, a stock split may make a company more attractive to index funds that seek to replicate the performance of important indices.

How a Stock Split Works

As previously mentioned, a stock split is an action taken by a company to increase its available number of shares by issuing more to existing shareholders. A proportionate decrease in price follows this; however, the total value of your investment stays the same.

Below is a simple illustration of how this works.

• Before the Split

Let’s assume you own 1000 shares priced at $250 each at Amazon.com Inc, bringing your total investment to $230,000. If the company announces a 2-for-1 stock split, your quantity of shares will now be 2000. Since the number of shares is doubled, the price per share is halved to $125, with your shares’ value remaining at $230,000.

• After the Split

After the stock split, you own more shares, but the price per share is reduced. At that price, the company’s stock becomes more affordable while its market valuation stays unchanged and can attract more investors. You must bear in mind that this action does not change the company’s earnings or fundamentals.

For investors, the main impact is that the stock is now more affordable and liquid, allowing for easier buying and selling, and potentially increasing trading activity.

Types of Stock Splits

There are two primary types of stock splits, depending on whether the split affects the price or quantity of shares. They include the forward splits and reverse splits, with each serving different purposes.

1. Forward Stock Split

This is the most common type of stock split, and it involves increasing the circulating number of shares with a proportionate price decrease. As previously mentioned, the purpose of this action is to make the stock more affordable and accessible to a larger pool of investors. For instance, a 2-for-1 split means that for every share you own, you will receive one additional share, but the price per share will be cut in half. Other common ratios you’re likely to see include 3-for-1, 5-for-1, and 10-for-1.

For a company to opt for this type, there’s likely a significant rise in its stock price, and it probably wants to maintain liquidity and attract new investors. For instance, companies like Apple (AAPL) and Tesla (TSLA) have used forward stock splits to make their stocks more accessible while signalling strong market performance. In general, a forward split is seen as a bullish signal that indicates a company’s confidence in its future growth.

2. Reverse Stock Split

A reverse stock split, on the other hand, involves reducing the quantity of shares in circulation with a corresponding price increase. Usually, a company would opt for this option when its stock price has fallen too low and risks being delisted from major exchanges. As in a forward split, the typical reverse split ratios include 1-for-2, 1-for-5, and 1-for-20.

Reverse stock splits are often seen as a sign that a company is trying to boost its image or reduce volatility. However, they can be perceived negatively, as they sometimes indicate financial trouble or that a company is struggling to meet exchange listing requirements. Despite this, they are not always a bearish signal and can help a company attract institutional investors or stabilize its stock price.

Are Stock Splits Good for Investors?

Stock splits, especially forward splits,  are commonly viewed as positive for investors. This is because companies employ them after a good stock performance, and it reflects management’s confidence in the continuation of growth. Moreover, it makes shares more affordable, increases liquidity, and often boosts investor sentiment, pushing stock prices further in the short term. NVIDIA’s 2024 10-for-1 split led to over 30% gain in the weeks that followed the announcement.

However, for a company to opt for reverse stock splits, there is a high tendency of potential troubles, such as falling stock prices or financial instability in that company. While they aim at avoiding delisting or making their stock price more stable, it can be a warning sign for investors. Therefore, there is a need to evaluate and understand the intent behind such action.

Evaluating Stock Splits: What Should You Look Out For?

When a company opts for a stock split, the fundamentals, growth prospects, or financial health are usually not affected. Only the price and quantity of shares in circulation are affected. Therefore, when you evaluate a stock split, you should consider the performance, growth potential, and market conditions of that company rather than the split itself.

While splits don’t guarantee high value, they can boost shareholder value indirectly by attracting more investors and reinforcing growth momentum.

Stock splits come in different ratios, each having a different effect on the amount of shares and the price of one share. Here’s an explanation of common split ratios:

For Forward Splits:

• 2-for-1: A stock split that doubles the share count while reducing the share price by half.
• 3-for-1: Triples the number of shares, with the price per share being reduced to one-third.
• 5-for-1: Common for fast-growing companies to make shares more affordable and liquid.
• 10-for-1: A more dramatic split that greatly increases accessibility for small investors.

For Reverse Stock Splits

• 1-for-2: The number of shares is halved, while the share price is doubled.
• 1-for-5: This significantly reduces the share count and is usually used to raise the price above a threshold, such as $5–$10 per share.
• 1-for-20: This could be used for retaining listings on the exchanges or stabilizing a firm’s price.

When you understand how these ratios work, you can estimate how the share count and price will be adjusted. For instance, after a 2-for-1 split, you will have twice as many shares, but the price per share will be halved.

How Stock Splits Affect Trading and Investment Strategies

Stock splits can have different implications for both short-term traders and long-term investors:

Short-Term Traders

• Increased Volatility and Liquidity: Stock splits are usually accompanied by increased trading volumes and, therefore, heightened liquidity, making it easier to take and liquidate positions.

• More Trading Opportunities: The split date may catalyze events of momentum and volume spikes, thus giving opportunities to short-term traders.

• Focus on Market Reaction: Short-term traders often trade the post-split momentum by taking advantage of the surge in demand and liquidity.

Long-Term Investors

• Easier Access to Shares: Stock splits lower the price per share, making it easier for long-term investors to buy in at more affordable levels.

• Improved Diversification: The investors now have more shares at a reduced price, thus enabling them to diversify without increasing their total investment.

In the event of such splits, you can adopt these Best Stock Trading Strategies for increased profitability, whether as a short or long-term trader.

Conclusion

As an investor, you should understand that in effecting a stock split, the quantity of stocks can rise or fall with a proportionate change in price. This implies that the worth of your investment remains unchanged. What happens after a stock split in your company depends on the type of split that the company opts for and the rationale behind it. Forward stock splits are commonly valuable for making stocks more accessible and affordable. They also signal the company’s confidence in the stock in the coming years. Reverse stock splits, on the other hand, may mean that the stock is facing some financial problems due to its falling stock price.

Irrespective of the type of splits your company chooses, they do not alter the fundamentals of the business. Instead, understanding the reasons behind the splits will enable you to assess market prospects and ascertain whether the action is indicative of strength, instability, or merely a tactical change.