What are Stock Splits & Reverse Splits & Do They Work?

Companies Use Stock Splits To Reduce the Stock Price of Their Shares By Increasing The Number of Stocks In Circulation. But Do Splits Work?

Why do Companies Split Stocks?

When a company is very successful, its stock price rises.  Sometimes the stock price becomes so large that it becomes difficult for the ordinary investor to buy them in a round lot.  Investors usually buy stock in round lots of 50 or 100.

So, if an investor has $5,000 and they want to buy stock ABC at$50 per share, then they can buy 100 stocks for $5,000.

However, if XYZ company stock was priced at $300, the investor could only purchase 16 stocks.  This can be a barrier to some investors and could even suppress the stock price.

Stock Splits, What are They & Do They Work?

What is a Stock Split?

To counteract this, XYZ company can announce a stock split; also called a Scrip Issue in the UK.

This means if the XYZ company with a stock price of $300 did a 3 for 1 split.  Each shareholder would receive 2 extra shares for each share they own.  This triples the number of shares in circulation but also divides the stock price by 3 to $100 per share.  This means our investor could then buy 50 stocks with his $5000.

What is a Reverse Split?

Reverse splits work in the opposite way, let’s imagine ABCMart had issued 100 million shares in the past, but the profits and revenues have contracted over the past few years to the point that the stock is only valued at $0.50, giving the company a market capitalization of $50 million.

This low stock price looks bad for a company, as many investors will only buy stock valued above $5.  Also, sub $1 stock prices mean a company could potentially be delisted from an exchange, which could further depress price and liquidity.  So companies can choose to do a reverse split.

ABCMart decides to reverse split 5 to 1.  This means that for every five stocks that an investor holds, they would get only one stock; however, the stock price would then increase to $2.50.  The total number of outstanding shares would reduce from 100 million to 20 million, and the market capitalization would remain the same at $50 million.

So, nothing has actually changed except that the number of shares outstanding decreased, and the value of the shares increased.

Do Stock Splits Work?

All evidence suggests that stock splits are effective in enticing investors with smaller portfolios to buy the stock. The lower stock price makes the shares more accessible. Although splits are becoming less effective because many brokers are now allowing fractional share purchases.

Stock Split Summary

A stock split is a way for a company to manipulate the stock price to target it optimally for investors to purchase.  A reverse stock split can be a sign of a contracting business; however, a stock split is a sign of a growing business that wishes to keep its stock price within the boundaries for an ordinary investor to purchase.

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