Stock splits: what are they and how do you trade one?

Looking for something specific? Jump ahead with these links:

1. What is a stock split?
2. Why do companies split their shares?
3. How does a stock split work?
4. How to calculate a stock split
5. Stock split vs reverse split
6. How to know when a stock split will happen

1. What is a stock split?

A stock split occurs when a company divides its existing shares into multiple new units of ownership. The number of shares outstanding will increase by a set multiple, but the total value of the shares (known as the company’s market capitalisation) stays the same as before the split.

However, as stock splits can have an impact on the public’s perception of a company’s value – and the affordability of its shares – its share price can change following the corporate action.

The most popular split ratios are 2-for-1 or 3-for-1 (2:1 or 3:1). So, a shareholder that owned one share before the split would own two or three shares after the split.

2. Why do companies split their shares?

Companies split their shares to lower the cost of their stock, making each quoted share in the firm cheaper. In theory, this encourages more investment as the shares become more affordable for a greater number of people.

A company might decide it’s time to act because the share price has become too high, making it ‘overbought’ or expensive compared to other companies in its sector.

Despite each individual share becoming cheaper, the corporate action can be positive for the company, as it can stimulate growth. Investors might assume their growth trajectory will continue in the future even after the split. So, once the shares are more affordable, it’s likely a greater number of investors will buy into the company – raising its share price.

A confident board of directors often engineers stock splits with a clear plan and strategy, sending a positive message to analysts who might recommend the firm to investors.

After a stock split, existing shareholders might buy more stock. They know the market cap hasn’t altered, but they retain confidence in the firm and don’t want to miss the opportunity to buy more shares at the new lower price.

A stock split can also increase the public’s awareness of the company if it’s featured in the financial and mainstream press.

3. How stock splits work

Stock splits work by automatically adjusting the price of shares in the market; a shareholder doesn’t have to do anything, although large shareholders may be asked to approve the measure.

The company’s directors can decide to split the stock in several ways to make each share cheaper and more attractive to a broader base of private and institutional investors. For instance, a stock split might be 2-for-1, 3-for-1, 4-for-1, etc.

4. How to calculate a stock split

Calculating a stock split depends on the predetermined multiple a company has chosen. For example, a 2-for-1 stock split means that the outstanding shares in the market will double, as there will now be two shares for every previously owned single share.

The price of each share after the 2-for-1 stock split gets reduced by dividing the price in half. However, the company’s market capitalisation stays the same after the split.

For example:

• If XYZ PLC has 10 million shares floated, and the shares are trading at $100, the market cap is 10 million shares x $100 = $1 billion
• If the board of directors at XYZ split the stock 2-for-1, the number of outstanding shares doubles to the new figure of 20 million
• The share price gets halved to $50, leaving the market cap unchanged at 20 million x $50 = $1 billion

5. Stock split vs reverse split

A stock split and a reverse split are the complete opposite of each other. The outstanding shares get increased following a stock split, whereas after a reverse split, the number of shares decreases. A reverse stock split is sometimes considered an adverse corporate action, in contrast to the positive reaction a stock split typically receives.

Reverse stock splits often get judged as defensive. Investors can be suspicious that a company board is desperately trying to increase the share price. When a corporation’s stock falls to a certain level it can be in danger of delisting from a stock exchange. To avoid that fate, a company can reduce the shares available to raise the price per share.

With a stock split, the split gets announced as 2-for-1 or 3-for-1 etc. With a reverse split, it’s quoted as 1-for-2, 1-for-3 etc.

The reverse stock split might not get the welcome the board hoped for, as short sellers might target the company because they believe the new price is inflated and the firm is overvalued.

6. How to know when a stock split will happen

To know when a stock split will happen, you have to pay attention to company news for any firm you’re interested in. The firm is obliged to inform the stock exchanges and shareholders of the impending change.

When stock splits get announced, most financial news outlets will cover the story, and you’ll get to see the scheduled date for the split, the stock split ratio, the current price and the target price once the split takes effect.