What is a Stock Split & How Does it Work?

A stock split is a corporate action that involves dividing a company's existing shares into multiple new shares to increase the total number of shares outstanding. This is technically known as a "forward stock split." While the number of shares increases, the total value of the shares remains the same, meaning the market capitalization of the company is unchanged. For instance, in a 2-for-1 stock split, each existing share is split into two shares, and the price per share is halved. 

Oftentimes, stock splits are intended to make a company’s underlying shares more affordable to a broader base of investors. When a company's stock price has risen significantly, it can become expensive for smaller investors to purchase even a single share. By lowering the price per share through a split, companies can enhance the relative attractiveness and liquidity of their shares in the marketplace. Increased liquidity can lead to narrower bid-ask spreads and more efficient trading, benefiting both the company and its investors.

Stock splits usually occur after a strong bull run that pushes a company's stock price to high levels, often into the hundreds of dollars per share. High stock prices, while indicative of strong performance, can be a barrier to entry for some investors. By splitting the stock, companies aim to democratize ownership, allowing more investors to buy and trade their shares. This broader participation can further stimulate market activity and support the company's stock price over the long term.

Corporate actions like stock splits are significant events that impact stakeholders, including shareholders and bondholders. These actions are undertaken to manage the company's capital structure and marketability. While a stock split does not inherently change the company's value, it can have psychological and practical effects on how the stock is perceived and traded. Investors often view stock splits positively, interpreting them as a signal of the company's strong performance and future growth prospects.

The mechanics of a stock split involve increasing the number of a company's outstanding shares by issuing more shares to existing shareholders. The most common types of forward stock splits include ratios such as 2-for-1, 3-for-1 and 4-for-1. Each of these ratios indicates the number of new shares that will be issued for every existing share held by shareholders.

Additional information on some of the most popular types of stock splits is highlighted below:

• 2-for-1 Split: For every one share an investor holds, they receive an additional share, effectively doubling the number of shares. If the price was $200 before the split, it will be $100 after the split.

• 3-for-1 Split: For every one share held, investors receive two additional shares, tripling the number of shares. If the price was $300 before the split, it will be $100 after the split.

• 3-for-2 Split: For every two shares held, investors receive one additional share, increasing the number of shares by 50%. If the price was $150 before the split, it will be $100 after the split.

• 4-for-1 Split: For every one share held, investors receive three additional shares, quadrupling the number of shares. If the price was $400 before the split, it will be $100 after the split.

• 10-for-1 Split: For every one share held, investors receive nine additional shares, increasing the number of shares tenfold. If the price was $1,000 before the split, it will be $100 after the split.

In each case, while the number of shares increases and the price per share decreases, the overall value of the investment remains the same. The company’s market capitalization is unchanged, ensuring that the intrinsic value of the company and the shareholder's investment do not change despite the increase in the number of shares owned.

Example One

To understand the mechanics of a stock split, let’s consider the recent example of Nvidia Corp (NVDA), which announced a 10-for-1 stock split in June of 2024.

Before the Split

• NVIDIA Corporation had 2.462 billion shares outstanding.

• The stock price was approximately $1,219 per share.

• The market capitalization of NVIDIA Corporation was $3 trillion (2.462 billion shares x $1,219 per share).

After the 10-for-1 Split

• For every one share held, shareholders received nine additional shares. So if a shareholder owned 100 shares before the split, they would now own 1,000 shares.

• The number of shares outstanding increased tenfold to 24.62 billion shares.

• The stock price was divided by ten to approximately $121.90 per share.

• The market capitalization remained unchanged at $3 trillion (24.62 billion shares x $121.90 per share).

Example Two

Now let’s consider a hypothetical example involving XYZ Corporation. Suppose XYZ Corporation announces a 2-for-1 stock split.

Before the Split

• XYZ Corporation has 1 million shares outstanding.

• The stock price is $200 per share.

• The market capitalization of XYZ Corporation is $200 million (1 million shares x $200 per share).

After the 2-for-1 Split

• For every one share held, shareholders receive one additional share. If a shareholder owns 100 shares before the split, they will own 200 shares after the split.

• The number of shares outstanding doubles to 2 million shares.

• The stock price is halved to $100 per share.

• The market capitalization remains unchanged at $200 million (2 million shares x $100 per share).

A stock split affects the stock price by proportionally reducing it based on the split ratio. For example, in a 2-for-1 stock split, the number of shares outstanding doubles, and the stock price is halved. This adjustment ensures that the overall market capitalization of the company remains unchanged.

While the price per share decreases, the total value of an investor’s holdings remains the same. For instance, if a stock was priced at $200 per share before a 2-for-1 split, it would be priced at $100 per share after the split. If an investor owned 100 shares before the split, they would own 200 shares after, with the total value of their investment remaining constant.

Companies typically choose to execute stock splits in order to enhance the marketability and liquidity of their shares. A stock split reduces the price per share, making the stock more affordable to a wider range of investors, particularly retail investors. This lower price can attract more buyers who may have been hesitant to purchase high-priced shares, broadening the investor base.

By increasing the number of shares outstanding and lowering the price per share, stock splits can also improve liquidity. Higher liquidity means more shares are available for trading, which can lead to narrower bid-ask spreads and easier transactions. This improved liquidity benefits both current shareholders and potential investors.

Additionally, a stock split is often perceived as a signal of confidence from the company's management, suggesting expectations of continued growth and strong performance. This positive signal can boost investor sentiment and potentially increase demand for the stock. Companies may also split their stock to maintain the price within an optimal trading range, making it more attractive to investors.

Overall, stock splits are strategic decisions aimed at making the stock more accessible and appealing to a broader audience, thereby fostering a more dynamic and liquid market for the company's shares.

Stock splits offer several advantages that can benefit both the company and its shareholders. One of the primary advantages is improved affordability. By reducing the price per share, stock splits make the stock more accessible to a wider range of investors, particularly those who might find high-priced shares prohibitive. This can attract more retail investors and broaden the shareholder base.

Another significant advantage is increased liquidity. Stock splits increase the number of shares available for trading, which can lead to narrower bid-ask spreads and more efficient trading. Higher liquidity facilitates easier buying and selling of shares, benefiting both existing shareholders and new investors by providing a more dynamic and responsive market.

Stock splits can also enhance investor perception and confidence. A split is often seen as a positive signal from the company’s management, indicating confidence in future growth and strong performance. This can boost investor sentiment and potentially lead to higher demand for the stock, supporting its price over the long term.

Furthermore, stock splits help maintain an optimal trading range. Many companies believe there is an ideal price range for their shares that attracts the maximum number of investors. By bringing the share price down into this range, stock splits can ensure the stock remains attractive and accessible.

Overall, stock splits are a strategic tool that can enhance marketability, liquidity, and investor perception, contributing to a healthier and more active market for the company’s shares.

While stock splits offer several advantages, they also come with potential disadvantages. One primary concern is the perception that a lower stock price might indicate the company's stock is less valuable or has reached its peak. This perception can sometimes deter institutional investors who prefer higher-priced stocks.

Another disadvantage is the potential for increased volatility. With more shares outstanding at a lower price, smaller price movements can lead to larger percentage changes, potentially attracting more speculative trading. This can increase short-term volatility and impact the stock's stability.

Additionally, stock splits do not change the fundamental value of the company. Some investors may misinterpret the increased number of shares as an increase in value, which can lead to unrealistic expectations and potential disappointment if the stock does not perform as anticipated post-split.

Lastly, there are administrative and transactional costs associated with executing a stock split. While these costs are typically not substantial, they do represent an additional expense that the company must bear.

In summary, while stock splits can enhance marketability and liquidity, they also come with potential drawbacks such as perception issues, increased volatility, misinterpretation of value, and associated costs.

Stock splits and reverse stock splits are both corporate actions that adjust the number of a company's outstanding shares and the price per share, but they serve different purposes and have opposite effects.

A stock split increases the number of outstanding shares while reducing the price per share. For instance, in a 2-for-1 stock split, each existing share is split into two, doubling the number of shares and halving the price per share.

Conversely, a reverse stock split reduces the number of outstanding shares and increases the price per share by consolidating existing shares. For example, in a 1-for-10 reverse stock split, every ten shares a shareholder owns are converted into one share.

Companies execute reverse stock splits to increase their share price, making the stock more attractive to investors. Reverse stock splits are also typically pursued to meet listing requirements on stock exchanges, which often require a minimum share price. Reverse stock splits are more characteristic of bear markets, where companies may experience a significant decline in share value and seek to improve their stock's perception and stability.

In essence, the key differences between a stock split and a reverse stock split lie in their purpose and market association. Stock splits aim to make shares more affordable and improve liquidity, typically occurring in strong market conditions. In contrast, reverse stock splits seek to boost share prices and meet regulatory requirements, often in response to declining share values. While stock splits reduce the price per share and increase the number of shares, reverse stock splits have the opposite effect, decreasing the number of shares and raising the price per share.

If your shares undergo a stock split, it is important to understand the implications of the split, and your potential choices going forward. Some of these key considerations are highlighted below: 

• Review Share Count and Price: After the split, the number of shares you own will increase according to the split ratio, while the price per share will decrease proportionately. For example, if you owned 100 shares priced at $200 each before a 2-for-1 split, you will own 200 shares priced at $100 each after the split. The total value of your investment remains the same.

• Review Your Brokerage Account: Monitor your brokerage account to ensure that the new share count and adjusted price per share are accurately reflected. This update typically occurs automatically on the effective date of the stock split.

• Assess Any Impact on Your Investment Strategy: Consider how the stock split impacts your overall investment strategy. While a stock split does not change the fundamental value of your investment, the increased number of shares and lower price per share may influence your future trading decisions.

• Monitor Market Reactions: Observe how the market reacts to the stock split. Stock splits can sometimes boost investor sentiment and trading activity, potentially impacting the stock’s performance in the short term. This may impact your outlook and/ior investment strategy.