Stock splits are a way companies can lower their share price to attract smaller investors.
Fahrul Azmi via Unsplash; Canva
What Is a Stock Split and How Does It Work?
A stock split is an action taken by a company’s leadership to increase the total number of shares of its stock in circulation and decrease the price per share proportionately.
For instance, in a 2-for-1 stock split, 100 shares of a stock worth $50 per share would instantly become 200 shares of stock worth $25 per share. An investor who was holding 5 shares at $50 each for a total of $250 worth of stock would suddenly be holding 10 shares at $25 dollars each, still with a total value of $250. Not all splits are 2-for-1, though; 3-for-1, 5-for-1, and 10-for-1 splits are also common.
While stock splits change the number of outstanding shares and the price per share, they do not change the market capitalization of a company (i.e., the total value of all outstanding shares, or the company’s current market value). In other words, stock splits do not affect the value of an investor’s holdings; they simply increase the number of shares held and decrease the value of each share proportionately.
Why Do Companies Perform Stock Splits?
A company may choose to split its stock for a number of reasons. Most commonly, splits are performed to increase liquidity by increasing the number of shares outstanding while making a company’s stock more accessible to average investors by lowering share price.
These days, the trading of fractional shares is common thanks to newer trading platforms like Robinhood and SoFi, but this was not always the case. Historically, investors had to buy whole shares of stock if they wanted to invest. For institutional investors with lots of trading capital, buying shares that cost thousands of dollars was reasonable, but for retail investors (i.e., normal, working-working class, individual investors), a high share price could put a company’s stock out of reach.
Nowadays, retail investors don’t need to buy entire shares to invest in a company (Robinhood allows users to buy into a company’s stock with as little as $1), so stock splits are no longer strictly necessary in order to make a stock more accessible. Nevertheless, lower share prices do still seem to make buying whole shares of stock more psychologically palatable to the average investor, and companies do continue to execute splits.
In addition to making a stock more attractive by lowering the price per share, a split also tends to shorten the bid-ask spread (the difference between a seller’s lowest price for a share and a buyer’s highest price) by increasing the number of shares in circulation.
In a 3-for-1 stock split, one share worth $60 would immediately become three shares worth $20 each.
Stock Split Example: Apple (NASDAQ: AAPL)
In late August of 2020, Apple executed a 4-for-1 stock split in order to increase its outstanding shares fourfold while reducing share price by the same factor. This split changed Apple’s stock price from about $500 per share to about $125 and brought its number of shares outstanding from about 12.6 billion to about 50.4 billion. This means that an investor who was holding 10 $500 shares pre-split would have held 40 $125 shares post-split.
How Do Splits Affect Stocks in the Long Term?
While stock splits do not change a company’s market value when they occur, they can stir up interest, which can have a positive effect on share price in the immediate aftermath of the split or its announcement. This effect may be short-lived, but overall, repeatedly splitting stock to lower share price can keep investors bullish. If a company splits its stock repeatedly to remain affordable, investors tend to view it as a healthy and rapidly growing firm that is worth attention.
That being said, not every split results in gains or causes a buzz among investors. Every situation is different, and fundamentally, splits don’t affect a company’s value unless the market decides that they do.
What Is a Reverse Stock Split and How Does It Work?
A reverse stock split is essentially the opposite of a regular, or “forward” stock split. Instead of increasing the number of shares in circulation and decreasing share price, a reverse split reduces the number of outstanding shares and increases share price accordingly.
In a 1-for-2 reverse split, for instance, 100 shares with a price of $50 per share would become 50 shares worth $100 per share. Like a forward stock split, a reverse stock split does not impact a company’s market capitalization—it simply increases share price while decreasing the number of shares outstanding.
Why Do Companies Perform Reverse Stock Splits?
So, if forward splits decrease share price and increase liquidity—both of which are good things—why would a company want to perform a reverse split? Won’t increasing share price scare away smaller investors? Won’t reducing the total number of shares in circulation decrease trading volume and liquidity? Not necessarily.
The primary reason companies execute reverse splits is to meet the requirements to be listed on a major stock exchange like NASDAQ or the NYSE. To be listed on the NASDAQ, a stock must start at $5 or more per share, and to remain on the NASDAQ, a stock must maintain a price of at least $1 per share. Similarly, a stock must remain at or above $1 to trade on the NYSE. If a stock’s price remains below its exchange’s minimum for 30 days, it risks being delisted.
If a company cannot meet the requirements to get listed on one of the major exchanges, or if it becomes delisted, it must trade on the over-the-counter market, where liquidity is lower, bid-ask spreads are higher, trades take longer, and mainstream investor interest can be hard to come by.
For this reason, raising the price of a stock with a reverse split in order to get listed (or stay listed) on one of the major exchanges can actually boost (or maintain) liquidity and investor interest. Companies that are traded on NASDAQ or the NYSE enjoy far more visibility than those that trade over the counter, and their stocks are far easier for average investors to trade.
Reverse Stock Split Example: Citigroup (NYSE: C)
In May of 2011, financial services company Citigroup enacted a 1-for-10 reverse split, raising share price from around $4 to around $40 and reducing outstanding shares from about 29 billion to about 2.9 billion. This reverse split was executed in tandem with a reinstated dividend after the firm’s first profitable year since the 2008 financial crisis and subsequent recession in an effort to “reduce volatility while broadening the base of potential investors,” according to then-CEO Vikram Pandit.
How Do Reverse Stock Splits Affect Stocks in the Long Term?
Reverse stock splits can portend trouble, but how they affect a stock’s value in the longer term really depends on the situation. If a company executes a reverse split simply because they need to remain listed on a major exchange—especially if share price used to be well above the $1 threshold—investors may see this as a sign of distress, and bearish sentiment could drive the company’s value down even further.
On the other hand, if a newer, up-and-coming company conducts a reverse split to get onto a major exchange for the first time—especially if its share price on the OTC market has been going up—this could be seen as a positive signal that the company is expanding and welcomes the increased volume, liquidity, and exposure that come with the uplisting process.
