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How Do Stock Splits Work?

If a company announces a 2-for-1 stock split, that means that its shares outstanding will double. Thus, everyone who owns shares in the company will receive one additional share for each share they own. Since each share then represents half the portion of the company that it did before the stock split, each shareholder holds exactly the same proportion of the company as they did before. So, consider that a company’s stock was trading at $60 when the company decided to split the stock at 3-for-1. The company would then issue two shares of stock to each shareholder for every one share they owned. And after the split, the price of the stock would be $20 per share. So, a stock split doesn’t add any value to your portfolio in and of itself. It is similar to getting two $10 bills for a $20 bill.

Why Do Companies Split Their Stock?

Companies often split their stock when the price of their stock is so high that it is seen as unaffordable to the average investor. Berkshire Hathaway’s Class B shares were trading at around $3500 a share in 2010 when the company’s shareholders approved a 50-for-1 stock split, to yield a split-adjusted stock price of $69.50. This made buying the stock much more attainable to the typical investor as opposed to paying four figures for a single share of stock.

Are Stock Splits Good?

Stock Splits

Stock splits are almost universally regarded as good. It increases the interest of potential buyers, as smaller investors can now afford to invest in the stock and still be able to diversify their portfolios. Even though you ideally will want to own the stock at the time of the split, the lower price will still make the stock a great buy after the split.

What is a Reverse Split?

A reverse split is exactly the opposite of a conventional stock split. Instead of issuing additional stock, the company reduces its outstanding shares by merging multiple shares into one. Unlike a regular stock split, a reverse stock split is almost always a bad sign.

Companies often engage in reverse stock splits when the price of their stock doesn’t meet listing requirements. Many exchanges have rules that say a stock’s price must maintain itself above $1 for 30 days or so. If a company’s stock has been hovering between $0.80 and $0.90 for a few weeks, the company could initiate a 1-for-3 reverse split and issue one share for every three shares outstanding. This would make a $0.90 pre-split stock worth $2.70. However, just like a conventional stock split, the value of the company does not change nor does the value of your portfolio due to the split itself. If you had 18 shares of this company, worth $0.90, you would end up with six shares of the company worth $2.70. Both holdings add up to $16.20.

Reverse Split

Another reason why a company may enter into a reverse stock split is that some mutual funds and institutional investors have rules against buying stocks that fall below a certain price. Having a stock price that is too low can negatively affect a company’s reputation.

Reverse stock splits are often the action of a desperate company trying to stay listed or relevant. Such companies are not necessarily doomed, but the short-term prospects for such companies are not good. There are certain situations where reverse stock splits can be a good thing. In 2011, Citigroup (C) initiated a 1-for-10 reverse split. The company had just emerged from the Great Recession and was doing well—even paying a dividend. The reverse split made Citi a $40 stock and the stock has traded as high as $80 in January 2020.

Conclusion

Stock splits are a way for companies to reduce the price of their stock by reducing the fraction of a company represented by each share. Shareholders receive additional shares for each share they own in the company, depending upon the ratio of the split decided. This manipulation in the number of outstanding shares allows smaller investors to afford the stock.

Reverse splits are the exact opposite of conventional splits are often an “it can’t get any worse” measure. However, after dramatic challenges or economic downturns, this could be a good thing. When a stock’s value has been beaten down excessively and the future looks bright, a reverse split can be a way to “return value to shareholders.”