What Happens After a Stock Split

Reviewed by Thomas BrockFact checked by Amanda Bellucco-ChathamReviewed by Thomas BrockFact checked by Amanda Bellucco-Chatham

The mere mention of a stock split can get an investor’s blood rushing. But are they worth all the excitement? It depends on why they happen and what it means to the investor.

Say you have a $100 bill and someone offers you two $50 bills in exchange . Most people won’t get excited over a proposition like this because you still end up with the same amount of money. Stock splits present similar situations for people in the investment industry.

Key Takeaways

• In a stock split, a company divides its existing stock into multiple shares to boost liquidity.
• Companies may also do stock splits to make share prices more attractive.
• For shareholders, the total dollar value of their investment remains the same because the split doesn’t add real value.
• The most common splits are two-for-one or three-for-one. A stockholder gets two or three shares respectively for every share held.
• A company divides the number of shares that stockholders own in a reverse stock split, raising the market price accordingly.

What Is a Stock Split?

A stock split is a corporate action by a company’s board of directors that increases the number of outstanding shares. It’s accomplished by dividing each share into multiple shares, diminishing its stock price.

A stock split does nothing to the company’s market capitalization. This figure remains the same. Each stockholder receives an additional share for each share held in a two-for-one stock split but the value of each share is reduced by half. Two shares now equal the original value of one share before the split.

Let’s say Stock A trades at $40 and has 10 million shares issued. This gives it a market capitalization of $400 million or $40 x 10 million shares. The company then implements a two-for-one stock split. Shareholders receive another share for each share they currently own.

Now they have two shares for each one previously held but the stock price is cut by 50% from $40 to $20. The market cap stays the same, doubling the number of shares outstanding to 20 million and simultaneously reducing the stock price by 50% to $20 for a capitalization of $400 million.

The true value of the company hasn’t changed at all.

Common Stock Split Ratios

Stock splits can take many forms but the most common are two-for-one, three-for-two, and three-for-one. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. Using the example above, divide $40 by two to get the new trading price of $20. Do the same for a three-for-two split: 40/(3/2) = 40/1.5 = $26.67.

Note

Reverse stock splits are usually implemented because a company’s share price loses significant value.

Reverse Splits

Companies can also implement a reverse stock split. A one-for-10 split gives you one share for every 10 shares you own.

This is the effect a split would have on the number of shares, share price, and the market cap of the company doing the split:

Reasons for Stock Splits

Companies consider carrying out a stock split for several reasons. The first is psychology. Some investors may feel that the price is too high for them to buy as the price of a stock gets higher and higher but small investors might feel that it’s unaffordable. Splitting the stock brings the share price down to a more attractive level. The actual value of the company doesn’t change but the lower stock price may affect the way the stock is perceived and this can entice new investors.

Note

Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before. They have more stock to trade if the price rises.

Another reason companies consider stock splits is to increase a stock’s liquidity. With a lower price, more shareholders can afford to invest in high-value companies, ultimately increasing the market for that company’s stock. Stocks that trade above hundreds of dollars per share can result in large bid/ask spreads.

None of these reasons or potential effects agree with financial theory, however. Splits are irrelevant yet companies still do them. Splits are a good demonstration of how corporate actions and investor behavior don’t always fall in line with financial theory. This has opened up a wide area of financial study called behavioral finance.

Advantages for Investors 

There are plenty of arguments over whether stock splits help or hurt investors. One side says a stock split is a good buying indicator, signaling that the company’s share price is increasing and doing well. This may be true but a stock split simply has no effect on the fundamental value of the stock and poses no real advantage to investors.

Investment newsletters nonetheless take note of the often positive sentiment surrounding a stock split. Entire publications are devoted to tracking stocks that split and attempting to profit from the bullish nature of the splits. Critics would say this strategy is by no means a time-tested one and is questionably successful at best.

Pros

• Lower share price makes it more attractive for small investors

• More shares in the market can lead to increased liquidity

• Can boost investor sentiment and confidence

• Can signal management’s confidence in the company’s future performance

• Can make employee stock options more attractive

Cons

• May create a misleading perception of increased value or growth

• Can cause short-term volatility in stock prices

• Does not improve the company’s actual valuation or financial health

• Although the total earnings remain the same, EPS gets diluted, which can be perceived negatively

Example of a Stock Split

The chipmaker Nvidia (NVDA) announced a 10-for-1 stock split in May of 2024. This means that for every share of Nvidia stock an investor owned before the split, they would now hold ten shares–if an investor had one NVDA share valued at $1,000 before the split, they would have instead ten shares at $100 each after the split.

But note that the total value of the investor’s holdings and the company’s market capitalization remain unchanged. Before the split, NVDA’s market capitalization stood at just over $2.5 trillion, making it one of the world’s most valuable corporations. That figure represents 2.5 billion shares outstanding with a market price of roughly $1,000 per share. After the split, there will be ten times as many shares: 25.0 billion, with an initial value of around $100–which would still equal $2.5 trillion when you multiply the share price by the number of shares outstanding.

This move exemplifies how stock splits can help make high-value stocks more reachable for everyday investors while maintaining the same overall investment value.

In the past, buying before a split was seen as a good strategy to reduce trading costs due to commissions weighted by the number of shares you bought. It was advantageous only because it saved you money on commissions. This isn’t such an advantage anymore because most brokers offer a flat fee for commissions regardless of the trade size–and increasingly charge no commissions at all!

What Are Outstanding Shares?

Outstanding shares are those that are currently owned by someone or something other than the company itself. They’re held by the public, either through individual ownership or as components of a pension fund or mutual fund. Individual owners can be officers or employees of the company.

The company can no longer issue or sell these shares because they’re held by someone or something else.

Why Would a Company Do a Reverse Stock Split?

Companies typically do reverse stock splits to attract new investors. They tend to occur because companies believe their stock price is too low. Dividing the number of shares that stockholders own will proportionately raise the market price. Companies that perform this tactic are often smaller entities that trade in over-the-counter markets rather than on the major U.S. stock exchanges.

What Is a Class A Share?

Some companies issue shares of common stock divided into two or more classes, although approximately 90% issue only one class. The classes award different voting rights. Class A shares can award 10 votes per share compared to Class B shares which have only one vote per share.

The Bottom Line

A stock split increases the number of shares a company has, but it doesn’t automatically make anyone any richer. There are some psychological reasons why companies split their stock but the business fundamentals remain the same. However, the psychological value of a stock split can increase interest in the company’s equity.

Read the original article on Investopedia.