Stock Split - Definition
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Table of ContentsStock Split DefinitionHow a Stock Split WorksReasons for a stock splitExample of a Stock SplitReverse Stock SplitsAcademic Research
Stock Split Definition
A stock split is a transaction by a company dividing its current shares into two - resulting in twice as many outstanding shares. The company takes this step in order to increase its business by increasing the value of shares. There is a special multiple which helps increase the number of shares that the company has authorized, but there is no change in the total value of the shares in terms of dollar if we compare with the amounts that are already split. The reason behind it is that there is no addition to the real value in spite of split. There are some ratios regarding split but 2-for-1 or 3-for-1 are the most ordinary ones. It means if the stockholder holds some shares earlier, he will have two or three shares respectively. In summary:
- A stock split is an effort made collectively by a group of large companies that enables the company to develop the business by dividing its present shares into other many other shares. Using this scenario, the company can enhance its business.
- The number of shares that the company confirms, can be increased by applying a typical multiple-formula, without a change in the total value of the shares while replacing them with dollars. It is so because the split doesn't affect the real value.
- Amongst the ratios of the split 2- for-1 or 3-for-1 are the most usual. It is obvious that if there are some shares in a stockholders possession, he will get two or three shares respectively.
- Reverse stock-split is another type of split, but the opposite transaction. Its based on division, instead of multiplication of the number of shares with the stock-holder and helps the market-prices soar accordingly.
How a Stock Split Works
A stock split is a combined effort, according to which, a company adopts the strategy of dividing current shares into many other shares. Fundamentally, firms are compelled to split shares in order to decrease the cost of trading their stock to a level which most of the investors find to be convenient. It also raises liquidity of shares. Mostly, the investors believe that it would be better to purchase 100 shares of $10 stock instead of 10 shares of $100 stock. So seeing the increase to a great extent, it will be natural for companies to announce that there will be stock split later so as to decrease the price to a more trending price at which stock is traded. No doubt, a stock split results in adding the number of remaining shares, but there is no change in the value of shares when taken in dollars. Its only because the split doesn't make any addition to the real value. Application of the stock split, as well as the cost of shares, goes side by side. The Board of Directors decides to split the stock using a number of methods. For instance, there may be a stock split like 2- for-1, 3-for-1, 4-for-1, 5-for-1, 10-for-1, 100-for-1, etc. The meaning of 3-for-1 stock split is that the number of shares that the investor has, will triple for each share that the depositor holds. Opposite to it, after the 3-for-1 stock split, the price per share will be decreased by dividing the prices by 3. One has to multiply the total number of shares outstanding by the price of one share to calculate the market capitalization. Take it as an example that abc/someone 20 million shares outstanding and the value of one share is $100. We will multiply the number of shares (20) by the market value ($100). The answer will be 20 shares x $100 = $2 billion which will be the market capitalization. Now suppose, the Board of Directors enforces 2-for-1 formula to split the stock. As an outcome of this split, the number of shares outstanding will double and become 20million x 2 = 40million. But at the same time the price of share would reduce to half i.e. $100 divided by 2= $50. In this way the market capitalization will remain unaffected. It will be 40 million shares x $50= $2billion again. In the UK, a stock split is termed as bonus issue, scrip issue, capital issue, or free issue.
Reasons for a stock split
What is the reason for the companies to suffer both the trouble and the expenditure related to a stock split? There are many suitable reasons behind it. First of all, we can say that a split is generally required, in case the stock is too expensive for investors to get a standard board lot of 100 shares. For example: in 2014, the cost of the shares rose to about $700 per share and Apple Inc. issued a stock split based on 7-for-1 strategy. The board of directors viewed that it was a hard nut to crack for an average retail investor. It was then they made a number of shareholders more comfortable for purchasing the shares by implementing the stock split. But a day before the split was activated, $645 was declared as the last price. When the market reopened, Apples shares were trading at about $ 92 what we can say was the adjusted price after the 7-for-1 stock split. Secondly, the outcome of the greater number of shares outstanding can be greater liquidity of a stock which smoothens the trading and decreases the bid-ask spread. Trading in stock becomes easier for buyers and sellers when the liquidity increases. There is also wide adaptability which enables investors to trade shares in the company with little effect on the cost of shares. Though the split-in theory doesn't have much effect on stock price, it boosts the investors curiosity which ensures a good impact. This may not affect on a permanent basis, but the truth is that the stock splits, implemented by blue chip companies provide a vast opportunity to an average investor for acquiring more and more shares. A number of large companies declare a higher level of price than what it was when they split the stock, resulting in another stock split in the near future. Here, we can mention Walmart as a good example. Its prominent for splitting its shares about 11 times on a 2-for-1 basis from October 1970 to March 1999. An investors little stake of only 100 shares at Walmarts public offering would have risen up to 204,800 shares over the coming 30 years.
Example of a Stock Split
In June 2014, there was a split on 7- for- 1 basis by Apple inc. (NASDAQ: AAPL). This step was only to influence investors in a large number by making it accessible for them. The share, which was trading at $645.57 prior to the split, was priced at $92.70 at the market open, approximately 1/7 of 645.57. The company also gave six extra shares for every share to the existing shareholders. In this way, an investor, having 1000 shares of AAPL before split, would get 7000 shares after split. The number of Apples shares rose from 861 million to 6 billion, but there wasn't seen a big change regarding the market cap and it was $556 billion. The very next day after the stock split, the price had risen to $95.05. This immediate jump proved that the demand for the lower stock price had.
Reverse Stock Splits
A traditional stock split is the synonym of a forward stock split while a reverse stock split is the antonym of a forward stock split. A company that undertakes a reverse split, lowers the number of its outstanding shares, adding to the share price. There is no change in the market value in both the cases; either its a reverse stock split or a forward stock split. The company that takes this corporate action, has the right to do so (to issue a reverse or a forward stock split), in case, its share-price has come down to an extent that it has the fear of being out of exchange-list for not fulfilling the requirement regarding the minimum price. The provision of reverse stock split is there to lure the investors who may take it as more beneficial in spite of being expensive. Companies undergo a reverse/forward stock split to get rid of such shareholders who hold only a limited number of shares. Reverse and forward stock splits depend on each other. The shareholders, who hold a fewer number of shares than those they previously possessed, suffer loss because of reduction in overall number of shares as effect of the reverse split. But they are cashed out. On the contrary, the forward stock split lets the shareholder enjoy a growth in the total number of shares as compared to the ones that he or she already held.