Stock splits are utilized by issuers that believe their stock price is either too high or too low. Two types of stock splits exist. Forward stock splits increase the number of outstanding shares, while reverse stock splits decrease the number of outstanding shares.
Issuers enact forward stock splits if they feel their stock price is too expensive for the average investor. Let’s assume ABC Company’s stock price rises to $300 per share, which is relatively costly (most stocks trade between $30 - $150). Obviously, they do not want the stock to decline in value due to market movement; this would mean investors are losing money. Instead, ABC Company could consider decreasing its stock price without losing market value through a stock split. Forward stock splits increase the number of shares a stockholder owns, but the stock price decreases proportionately. Let’s work through a few examples.
A stockholder owns 100 shares of ABC Company at a current market price of $300 per share. How will a 2:1 forward stock split impact shareholders?
Each stockholder receives 2 shares for every 1 share owned.
To find the stock split factor, divide the first number by the second number:
To find the new number of shares, multiply the original number of shares by the stock split factor:
To find the price per share adjustment, divide the original price per share by the stock split factor:
Put it all together and compare before and after to confirm
As you can see, stock splits do not affect the overall value of an investor’s position. In our example, the investor starts with $30,000 of stock, and subsequently ends with $30,000 of stock. However, the number of shares owned increased, and the price per share decreased.
To further your confidence with stock split calculations, let’s take a look at the real-world story of Apple’s 7:1 stock split back in 2014:
Let’s see if you can do one on your own now.
A stockholder owns 300 shares at a current market price of $90 per share. The issuer performs a 3:2 stock split. What adjustment is made to the investor’s position?
What is the stock split factor?
How many shares will the stockholder end up with?
What is the new price per share?
Summarize the final result.
Issuers enact reverse stock splits if they feel their stock price is too cheap. Instead of waiting for market demand to increase the stock price, an issuer could perform a reverse stock split and see an immediate increase in their stock price.
Let’s go through a reverse split example together.
An investor owns 100 shares of stock at a current market price of $10. How will a 1:5 reverse stock split impact the position?
Each stockholder receives 1 share for every 5 shares owned.
To find the stock split factor, divide the first number by the second number
To find the number of shares adjustment, multiply the original number of shares by the stock split factor
To find the price per share adjustment, divide the original price per share by the stock split factor
Put it all together and compare before and after to confirm
Before you work through an example on your own, let’s learn of the real-world story of Citigroup’s reverse stock split in 2011:
Try one on your own now.
A stockholder owns 400 shares at a current market price of $20 per share. The issuer performs a 4:5 reverse stock split. What will the investor’s stock position become?
What is the stock split factor?
How many shares will the stockholder end up with?
What is the new price per share?
Summarize the final result.
As you can see, the stockholder always ends up with the same overall value ($8,000 in the last example) after a stock split occurs.
Stock splits (forward and reverse) affect all stockholders, so there is never a change in proportionate ownership. If an investor owns 25% of the outstanding shares in a company before a stock split, they’ll still own 25% of the shares after the stock split. Here’s an analogy - imagine you and three of your friends slice a pizza into fourths, giving each person a 25% pizza stake. Cutting your slice in half would be similar to a 2:1 forward stock split. Do you have more pizza slices? Yes. Is there less pizza per slice? Yes. Regardless, you still own 25% of the overall pizza!
To summarize, stock splits do not affect overall investment value. However, the price per share and the number of shares will change. Although stock splits are fairly insignificant in the long run, they do require approval* from stockholders.
*Stock splits (forward and reverse) affect a common stock’s par (face) value. While par value on common stock is a relatively unimportant accounting measure, actions impacting a stock’s par value generally require shareholder approval.
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