As an investor in the stock market, you might have heard about stock split along the way. Today we will dig into it and learn all about it.
If you are planning to sell or even buy a share of company, stock split is perfect for you.
What is Stock Split?
A stock split is a corporate action in which a company divides its existing shares into multiple shares to help boost the liquidity of the shares. You should know that the number of shares outstanding increases by a specific multiple. And the total dollar value of the shares would just remain the same. Compared to the pre-split amounts, because the split does not add any real value.
When you use stock split you should know that there are two common split ratios. The 2-for-1 and 3-for-1. These ratios mean that the stockholder will have two or three shares, respectively.
Since all publicly traded companies have a number of shares that are outstanding on the stock market, the company’s board of directors will be using stock split to increase the number of shares that are outstanding by issuing more shares to current shareholders.
In the UK, a stock split is also referred to as a scrip issue, bonus issue, capitalization issue, or free issue.
Now we will show you an example on how stock split works:
Market capitalization is calculated through multiplying the total number of shares outstanding by the price per share.
For example, assume that XYZ Corp. has 20 million shares outstanding and the shares are trading at $100. Its market cap will be 20 million shares x $100 = $2 billion. Let’s say the company’s board of directors decides to split the stock 2-for-1. Right after the split takes effect, the number of shares outstanding would double to 40 million. While the share price would be halved to $50, leaving the market cap unchanged at 40 million shares x $50 = $2 billion.
Why Do Stocks Split?
You may now wonder why stocks split. Basically, a stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector.
The primary motive is to make shares seem more affordable to small investors, even though the underlying value of the company has not changed.
Stock split has the practical effect on increasing the liquidity in the stock.
However, when a stock splits, it can also result in a share price increase following the decrease immediately after the split.
Since many small investors think that the stock is now more affordable and will buy the stock, they will end up boosting the demand and increase the prices.
Another reason why the price is increasing is that a stock split provides a signal to the market that the company’s share price has been increasing. People will assume that this growth will continue in the future.
Advantages and Disadvantages
Today, markets are much more complicated than simple logic. A stock split has its certain pros and cons that you should know about.
- Splitting It Yourself Will Help you Avoid Having Other People Split Your Stock For You – If a company choose not to split its stock, other people can create business out of it by selling the shares of their entity.
- Certain Investors Prefer Stocks That Keep Splitting – Since most of the successful companies are always splitting their stock every few years during their rapid growth phase. There is an aura of vitality around a company that needs to keep splitting its stock. To keep it in the $5 to $200 range per share.
- Investor Expectations of Price Ranges – Some investors are often puzzled by the cost of each share of a stock that has not yet been split. This is due to the majority of the companies splitting their value if it goes over $200 per share. Remember, by splitting its stock a company can avoid this confusion.
- More Shares are Available – The more stock has been split, the larger the quantity of individual shares that exist. This will potentially allow a wider number of people to own the shares.
- The Affordability of Each Share is Improved – Each share of the stock now has half the value it did before. If someone who would not buy a stock share that costs $250,000. He or she might buy a stock share that costs $125,000. So, any potential buyers of a share of stock may increase if the price of each share is lowered through a stock split.
- Listing Requirements – You have to maintain a certain minimum price per share to be listed on the exchange list. If a company splits its stock and then the value of the company falls. The shares may go down below this requirement and will be removed from the exchange list. There are some companies that fell into this situation. And they executed a reverse stock split in order to stay on the exchange list.
- People Treat Shares as More Sellable on a Whim if Each Share Costs Less – If a company does not split its stock. And the value of the company increases, each share will become expensive.
- Costs of the Split – There are legal and notification costs to doing the split. Since a company must make the appropriate Board of Directors resolution then notify its shareholders, exchanges, regulators, etc. It may seem strange to spend the money of the company on a stock split that has no real significant effect on improving the value of the company.
Stock split is hard to understand. Especially if you are just a beginner in the field of investing in stocks. But once you get to know about it, it will just be simple and easy to understand.
Remember, if you are planning to use stock split you have to make sure you have enough knowledge about it. So, once you started using it you will know what to do and what to avoid in the process.
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