In the public marketplace, companies have a finite number of shares outstanding. Stock splits are one way for a company to increase the number of shares outstanding without diluting shares owned by current investors.
The decision to conduct a stock split is made by the board of directors. The board may decide to take the number of outstanding shares and split them. They can split them in half. They can split them 3:1 meaning there will be 3 new shares for every 1 current share. An example would be as follows:
A company decides to conduct a 3:1 stock split. For every share currently owned, each shareholder receives two additional shares but at one third the price. A shareholder who owns 100 shares worth $30 per share prior to the split would now own 300 shares after the split, each share now only be worth $10.
You might be wondering why a company would do this. Since it is the job of the board of directors to maximize shareholder value, they may estimate that the share price is becoming too expensive, deterring smaller investors who would otherwise buy and keep the price of the stock going up. Limiting the number of investors can often limit the upside potential of the stock price so a stock split makes the cost of a share more appealing to those smaller investors looking to get in on the action.
What is a reverse stock split?
A reverse stock split is another tool the board of directors uses to add value for current investors. In a reverse stock split, the company reduces the number of outstanding shares causing the price per share to rise.
An example of a 1:2 split would mean a shareholder with 100 shares at $10 per share prior to the reverse split would have 50 shares worth $20 per share post-split. Companies will often do this when they feel the share price has fallen too low and needs to gain a level of respectability or even possible to prevent the stock from being delisted by the stock exchange. Depending on the exchange, a company’s stock can be removed if it’s price falls too low and for too long.
When a split occurs, the company will announce the split and indicate that it only applies to shareholders of a specific date. Shortly after the date, shareholders will either receive their additional shares while noticing a price drop, or they will see their number of shares decrease while the price gets boosted.
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