Why Do Companies Split Stocks?

John Smith

A company may decide to split its stock when the market price per share gets very high, making trading the shares more difficult. One key reason companies split stocks is that a high share price can deter smaller individual investors from purchasing the stock. Stock splits are often done after there has been a major surge in the company’s share price.

While stock splits don’t change the fundamentals of a company, they can facilitate more liquidity and accessibility. By dividing each share into more shares that are proportionately less expensive, more investors may feel comfortable buying the stock.

Additionally, high share prices could result in wider bid-ask spreads, increased volatility, and difficulty meeting listing requirements on certain exchanges.

How Stock Splits Work

A stock split increases the number of a company’s shares outstanding while proportionately decreasing the price of each share. For example, in a traditional 2-for-1 stock split, an investor who owned 100 shares at $200 per share would own 200 shares at $100 per share after the split.

Their total equity position remains unchanged at $20,000, but now more investors may feel that $100 per share is an affordable stock price.

Stock splits are usually structured as either traditional splits or reverse splits. In a traditional stock split, the share price decreases as more shares become available. This helps improve liquidity and facilitate smaller investments.

In contrast, a reverse stock split decreases the number of shares outstanding, thereby increasing the share price proportionately. Companies may pursue reverse splits to meet exchange listing standards requiring stocks to trade above a minimum per share price.

Importance for Shareholders

For existing investors, stock splits change the number of shares they own but have a neutral impact on their total dollar amount invested.

However, splits do offer benefits. The post-split lower market price may generate stronger retail investor interest, higher share liquidity, potentially lower volatility, and improved trading ranges.

Additionally, a split signals that management has confidence in the company’s future. Companies generally split stock when momentum is positive, and they expect share prices to continue rising post-split.

This functions as a reinforcement of the company’s strengths. Consequently, announcement of a stock split often catalyzes fresh enthusiasm in the stock, driving prices higher in the weeks surrounding the split.

Evaluating Stock Splits

When assessing stock splits, key metrics to analyze include the split ratio, timing, and rationale. The split ratio compares the number of shares owned pre and post-split.

Typical split ratios range from 2-for-1 up to 10-for-1, although even higher ratios are possible. Companies strive for a post-split price they believe is optimal to spur investment.

Meanwhile, timing can explain motivation. Splits occurring when prices reach all-time highs often signal management’s confidence in sustaining momentum. However, a plummeting stock price may likewise induce a reverse split to satisfy exchange listing mandates. Context illuminates intent.

Likewise, management’s commentary around a split can provide color. Companies cite various rationales, from expanding retail access to optimizing price levels to meeting exchange standards. The reasoning articulated can guide analysis. When paired with historic trends and peer comparisons, these factors help investors evaluate splits.

Risks and Downsides

Despite potential benefits, stock splits also carry downside risks. A poorly timed split undermines management credibility if the shares plunge post-split.

Additionally, lower post-split prices could hamper institutional interest. Institutions may have restrictions on stocks trading below certain price thresholds.

Meanwhile, the optical impact of more shares outstanding could cause inaccurate comparisons when screening tools use per share metrics. Models must adjust for the increase in number of shares.

Finally, splits may create tax implications in non-retirement accounts. Consultation with tax professionals is advisable upon receiving additional lower-cost-basis shares.

The Bottom Line

In summary, context is crucial. Stock splits in and of themselves do not alter corporate fundamentals. However, they can indicate positive trajectories and management expectations. By easing access for retail traders, splits support liquidity and shareholder democratization.

Evaluating environment, trends and motivations helps investors properly interpret splits. An information-based analysis of rationale and impact allows investors to leverage splits as a constructive indicator.

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John Smith is a veteran stock trader with over 10 years of experience in the financial markets. He is a widely followed market commentator known for his astute analysis and accurate predictions. John has authored multiple bestselling books explaining complex market concepts in simple terms for novice investors looking to grow their wealth through strategic trading and long-term investments.
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