Companies use stock splits to reduce the price of their shares, which can help attract new investors. Reverse stock splits, which increase the price of shares on the market, can help keep a company from being delisted by a stock exchange. Splits and reverse splits don't change the company's total market value of its shares in an individual investor's portfolio. Share prices are adjusted to reflect the ratio of the split, so after a 2-for-1 split shares trade at half the previous price. Consider talking to a financial advisor before investing in a company that has announced a stock split to see if it's a good fit for your portfolio.
How Stock Splits Work
When a company conducts a stock split, it increases the number of shares owned by investors. The price of the shares is reduced by the same amount. As a result, the total value of the company's market capitalization does not change. Nor does the value of the company's shares owned by investors.
Companies specify a certain ratio for a stock split. For example, a 2-for-1 split is common. This means an investor who has 100 shares will, after the split, have 200 shares. Splits may also occur on a 3-for-1, 4-for-1 or any other basis.
When the number of shares increases by the specified ratio, the price decreases by the same ratio. So an investor with 100 shares worth $20 each will, after the split has 200 shares worth $10 each. The value of the investor's holdings of stock remains at $2,000. Dividends, if any, are also adjusted by a split. A stock paying a $2 dividend will, after a 2-for-1 split, pay $1 per share.
Why Companies Split Stock
Companies generally split stock in order to attract investors. If a company's share prices have appreciated a great deal, many investors may not be able to afford even a single share. By reducing the price with a split, the company can make its shares easier to buy. This can boost liquidity and encourage new investment. Lower share prices can also help a company compete for investors against similar firms trading at lower prices.
Share prices often rise after a split, at least temporarily. This may be due to purchases by investors who wanted to buy but were put off by high prices or to the attention generated by the stock split announcement. Splits sometimes are interpreted as signs companies are financially healthy and growing, which can increase attention and investment. Over the long term, however, splits tend to have little impact on the value of an investment portfolio.
Reverse Stock Splits
Companies also use reverse stock splits, which reduce the number of shares and increase the price. That is, an investor with 100 shares would, after a reverse 1-for-2 split, have 50 shares. Price and dividends are also according to the specified ratio.
Increasing stock price via a reverse split is typically a move by a company trying to avoid being delisted by a stock exchange. Exchanges usually have minimum share prices for listed companies. If a company's shares are at or below that price, it may do a reverse split to raise them back into safe territory.
A reverse split can signal that a company is in financial trouble, especially if it is making the move to avoid delisting. For this reason, investors may tend to avoid buying into a company that has announced or recently completed a reverse split. However, sometimes a company that is doing well and in no danger of delisting will engineer a reverse split. This is likely motivated by the hope that investors will see a higher stock price as a sign that it is a good investment.
The Bottom Line
Stock splits and reverse stock splits change the price of a share without changing the total market value of the company or investors' holdings. Companies may split high-priced shares in order to make them more attractive to average investors. Stock splits may be seen as signs of financial health by investors. Reverse splits, on the other hand, are usually motivated by concerns about being delisted by an exchange for violating the exchange's minimum share price rules and could indicate a company in financial trouble.
Tips for Investing
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A financial advisor can help you interpret a stock split or reverse stock split and see if that stock is a good fit for your portfolio. If you don't have a financial advisor, finding one doesn't have to be hard. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
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Berkshire Hathaway, the holding company headed by famed investor Warren Buffett, has never split its Class A shares, which have traded at times for over $500,000 per share. Average investors can still own Berkshire Hathaway, however. The company's Class B shares, after a 50-1 split in 2010, are relatively affordable at a few hundred dollars apiece. Fractional share investing provides another way average investors can buy shares of Berkshire and other expensive stocks.
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The post What Is a Stock Split and Why Do They Occur? appeared first on SmartAsset Blog.
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