What is Stock Split? Everything You Need To Know
Stock splits have been in the news lately with Apple announcing a four to one stock split and Tesla announcing a five to one stock split. So, if you don’t know what that means you’ll learn that in this article however, stock splits have actually been around for years. We are going to learn what a stock split is. , why do stocks split between general what is the purpose behind them and what is a reverse stock split.
What is a Stock split?
A stock split is when a company increases its number of shares outstanding by issuing more shares to its current shareholders aka the people that already own the stock. For example, picture a pizza right now the pizza has no slices if I go through a stock split I’m simply just adding more and more and more slices to the pie. The pie still remains the pie but it now has more slices.
So, if you want to talk about a two-for-one stock split let’s take a company that has let’s call it one million shares outstanding and you’re basically doing a two-for-one to become the multiplier. You now issue two million shares so instead of eating you know one slice you’re eating two slices but getting the same amount of value if that makes sense.
How does stock split affect the stock price?
So let’s say for example we have a company that’s trading at a hundred dollars a share they go for a two-for-one stock split this now takes the number of shares outstanding multiplies them by two,you’re getting two million shares. However, the stock price is reduced by two or a half. The market cap actually remains the same so for those who don’t know what Market Cap is, it is just the number of shares outstanding multiplied by the share price.
For example in the company’s trading at a hundred bucks a share, let’s just say they have 10 shares, their market cap is a thousand dollars makes sense 100 times ten thousand bucks. Now, if they go for a two-for-one stock split okay the number of shares outstanding becomes twenty. However, the value is reduced to fifty dollars it’s still the same it’s still a thousand dollar market cap. So the value of the company is unchanged and we’ll talk about why stocks split and the need to play these games.
Why do stocks split?
It’s simply the perception of affordability. This is to make the share price look more affordable to smaller investors and retail investors. It is not for wall street, this is not for pension funds and not for institutional investors. This is typically a perception move to make it look more affordable however, remember what we just talked about the underlying market cap or the value of the company has not changed. You’re just creating more slices of one pie.
The other reason why companies do this is actually that it helps increase liquidity. If a stock price is super super expensive in the days of buying whole shares the liquidity was very low it’s hard to transact that big of an amount for retail investors now if you make the price the share price smaller it’s able to be bought and sold more thus increasing the liquidity of the stock. The perception of affordability actually goes up so for example The 100 stock now is trading at 50 oh! it looks more affordable.
However, there is a difference between price and value price. price is what you pay. value is what you get and at the time of this recording in mid-late 2020, a lot of people are forgetting about this facet of investing. After these stocks split what typically happens so top stocks typically go up after the split because the smaller or retail investors that we talked about may actually see the stock price being cheaper or more affordable when in fact it’s really the same market cap .
We saw this happening with both Apple and with Tesla. Both these stocks went up pretty significantly post split and then another reason why the price may actually go up is because people who perceive a company that needs to split their stock as a company that’s being very successful because the share price keeps going up and up and up. It’s becoming quote-unquote unaffordable for retail or smaller investors. People think if a stock is splitting that means that the price is going up which means it’s a healthy strong company it’s wise to invest in this company.
Reverse Stock Split
A Reverse stock split is literally just the inverse of a traditional split which is already explained. Why would companies want to do this so? Typically companies that have a low share price want to increase the price per share of their stock so what they do is reduce the number of shares outstanding. So instead of creating more slices, they reduce the number of slices in the pizza or the pie.
Why do companies want to do this?
so basically they may be perceived as stronger if their share price is higher. So the kind of like how these companies are doing the stock split as it wants to be perceived as more affordable. These companies with lower share prices want to be perceived as stronger than they actually are even though it only boils back down to the total market cap. But some exchanges actually won’t allow you to be listed if your stock price is too low you may become over the counter or pink sheets.
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