What is a Stock Split?
A stock split is a corporate action designed to increase the liquidity of the company’s stock by intentionally lowering the price of a single share. The split increases the number of shares outstanding by a certain multiple without changing the company’s total market value. The most common split ratios are 2-to-1 or 3-to-1, also displayed as 2:1 or 3:1, respectively. The value of each share is then divided by the multiple.
For example, the number of shares outstanding doubles with a 2:1 split. The price per share is then divided in half. After the split, existing shareholders will have twice the number of shares they did before the split, but each share will be worth half the price; thus, the total value of their shares remains unchanged.
For example, if a company has 100 existing shares and the stock is currently trading at $1,000 per share, it may want to do a stock split to lower the stock price to make it more affordable for investors looking to own a piece of the company. With a 2:1 split, the number of shares increases to 200, and each share is worth $500.
Executives and the board of directors can increase the number of shares outstanding by multiples, including 10:1 or even 100:1, although 3:1 and 2:1 remain the most common.
Companies typically split their stocks when the price per share rises quickly over a short period of time. Once the price surpasses a certain threshold, the company will split the stock to maintain a certain level of liquidity. The split makes it easier to sell the stock to investors by lowering the price of each share. Companies can use a stock split to raise capital quickly by selling shares for a smaller dollar amount.
There is no limit to how many times companies can split their stocks. A company can also do a reverse stock split to reduce the number of shares outstanding, which increases the price per share.
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What Is a 20-to-1 Stock Split?
A 20-to-1 stock split is when a company increases the number of shares outstanding by a multiple of 20. The price of each share is divided by 20 as a result.
For example, if a company owns 100 shares and the stock is trading at $1,000 per share, the 20:1 stock split would increase the number of shares outstanding to 2,000 (100 x 20 = 2,000). Meanwhile, the price of each share would be reduced to $50 per share (1,000 /20 = 50).
Is a Stock Split Good?
A stock split can be good for companies and investors that want to get in on the action, especially if the company is growing quickly and its stock prices have increased dramatically.
The stock split helps the company by increasing the liquidity of its shares. When the price of each share goes down, investors become more willing to buy in. Some may be unwilling to pay more than $100 per share, especially if they don’t have a lot of money to invest or aren’t sure if the company is a good investment. But they might be willing to buy shares if the price is reduced to $10 per share with a 10:1 stock split ratio.
Many investors and investment firms also purchase a standard board of 100 shares. Reducing the price per share makes this kind of investment more tenable.
The split may even increase demand for the company’s stock if investors are willing to buy the stock at a lower price point, which will increase the company’s stock prices.
Many start-ups and new companies pay their executives with stock options. The original investors in the company will also receive some of the shares in exchange for funding. Once the company becomes profitable, the original investors may want to cash in their shares for a profit. The company may also want to increase the number of shares to increase its cash flow and raise capital. Splitting the stock increases the number of shares each investor owns, so they can sell shares without completely giving up their stake in the company.
Reducing the price of each share also makes it easier for companies to buy back their stock to increase shareholder value. The move can also be a show of strength and confidence to investors, as lowering the price of each share gives it more room to increase down the line. In many cases, companies will see the stock prices return to the pre-split trading level after several years of growth.
Are There Disadvantages to a Stock Split?
Stock splits can also be cumbersome and expensive for companies. The stock split requires legal oversight and regulatory approval, which can cost thousands of dollars. Such an undertaking can be seen as a financial risk because the split will not affect the company’s total market value. It will count as a net loss unless the company can make up the expense in shareholder value.
Some companies prefer to retain ownership of their shares to limit outside influence. Increasing the number of shares gives outside investors a chance to gain influence in the company. They may even be able to gain control of the company if they purchase 51% of all shares outstanding.
The stock must also maintain a certain price point to be listed on a major trading index. For example, stocks on the Nasdaq must be traded for at least $1 per share. If the price per share drops below $1 for 30 consecutive days, the company will be given a warning with 180 days to comply with the trading standard. The company risks being removed from the trading index altogether if the price per share doesn’t increase to the minimum.
The Bottom Line
Stock splits are used to increase the liquidity of a stock by increasing the number of shares outstanding and reducing the price per share. The split doesn’t change the total value of the company’s shares. It is simply a different way of slicing up the total pie. It can be divided into as few pieces as possible, but the total shares still add up to the same dollar amount.