At times a corporation will declare a stock split. The best way to explain what happens is through an example.
Assume XYZ Corporation has 1,000,000 shares of 2 par common stock outstanding. Further assume, that at the time the stock splits the price of the stock is 100 per share and that the company is splitting its stock 2 for 1.
After the split, ABC Corporation will have 2,000,000 shares of stock outstanding, at a par value of 1 per share, and the stock price will be 50. Remember that par value has nothing to do with the market price of a stock.
How does this impact the individual investor?
Let’s say a person owned 500 shares of XYZ Corporation’s stock prior to the split. Before the split he had stock worth 50,000 (500 shares x 100 per share).
After the split he owns 1,000 shares of ABC Corporation stock at 50 per share. He still owns 50,000 worth of stock. Only now he has twice as many shares at half the price.
It’s the same principle as making change.
Assume I have a 1000 bill and ask someone for two 500 bills. After this person makes change for me I have twice as many bills, but they still add up to 1000. The other person still has 1000, but he has half as many bills.
Whether it’s stock or money or anything else, after the split, you’re no better off!
Generally, the reason a company decides to split their stock is to make it more attractive for investors to purchase. The reasoning is that more people will want to buy the stock at 10 rather than 20. It’s mostly psychological.
Further, as more people buy the stock at the lower price, the stock will rise in price. However, there is no guarantee that the stock will continue to rise in price after the stock split.
If there were, we would all profit handsomely by buying the stock on the day it splits and selling afterward at a higher price.
Unfortunately, just because the stock splits does not mean that it will rise in price after the split. Many times a stock declines in price after a split.
Another reason a company may want to declare a stock split is to make more shares available and broaden its stockholder base. Thus, the stock becomes more marketable and liquid!
Not all stocks split 2 for 1. Other popular ratios for stock splits are 3 for 1, 3 for 2, and 5 for 4.
However, the same principle holds true regardless of the ratio. The stock price will decline, the par value will decline, and the amount of shares outstanding will increase.
Reverse Stock Split
Like the term implies, a reverse stock split is exactly the opposite of a standard stock split. While a stock split divides a single share into a number of smaller shares, a reverse stock split takes a number of shares and combines them into one.
For example, in a three-for-one stock split, each share you own becomes three shares.
In a reverse three-for-one stock split, three shares become one. It’s important to note that the overall market capitalization of the company does not change.
The only reason a company reverse splits its stock is to increase the stock’s price by reducing the number of shares outstanding.