Occasionally, a company’s board of directors decides to split the firm’s stock.
Why do they do that? And how does it affect you as an investor if you’re holding on to the stock or thinking about getting into it?
In this post, I’ll be answering some of the most common questions around this topic.
What is a Stock Split?
A stock split is when a company divides its existing shares into multiple new shares. It is typically done in order to make the shares more affordable for investors, since the price of each the share will be lower after the split.
For example, if a company has 100 shares that are each worth $50, and it declares a 2-for-1 stock split, then post-split, the company will have 200 shares that are each worth $25.
It’s also worth noting that stock splits don’t change the value of a company or of an investor’s stake in the company.
For example, if you own one share of a company that is worth $100, and the company does a 2-for-1 stock split, then after the split, you will own two shares that are each worth $50. The value of your investment has not changed, you just have more shares that are each worth less.
The Different Types Of Stock Splits
There are different types of stock splits, but the most common is the “simple” or “regular” stock split, which is what was described in the example above.
Companies will sometimes do a reverse stock split, which is the opposite of a regular stock split. In a reverse stock split, the number of outstanding shares is reduced, and the price per share increases correspondingly.
So, if a company has 100 shares that are each worth $50, and it does a 1-for-2 reverse stock split, then post-split, the company will have 50 shares that are each worth $100.
Why Do Companies Do Stock Splits?
To Make Their Shares More Affordable
The main reason why companies do stock splits is to make their shares more affordable and therefore more attractive to potential investors.
When a company’s shares are expensive, it can be difficult for smaller investors to buy enough of them to have a significant stake in the company. But after a stock split, the same number of shares will be worth less, so smaller investors will be able to buy more of them.
To Drive Up Stock Prices
Because stock splits make it more affordable for more investors to buy a piece of the company, this can lead to an increase in demand for the company’s shares, which can drive up the stock price.
So, in addition to making its shares more accessible to small investors, a company may do a stock split in order to try to increase its stock price.
However, it’s important to note that stock splits don’t always have the intended effect. Sometimes, a company’s stock price will actually fall after a split.
This can happen if investors believe that the company is doing a stock split because its shares are overvalued and it is trying to artificially increase demand by making them more affordable.
In other words, sometimes investors see a stock split as a sign that a company’s shares are overpriced, and this can lead to a sell-off that drives the price down.
When Do Companies Do Stock Splits?
There is no set schedule for when companies do stock splits, but they typically happen when a company’s shares have become relatively expensive.
The best way to figure out whether a company’s shares has become expensive is to do a valuation on the stock. However, a quicker rough estimate method is to look at the company’s P/E (Price-to-Earnings) Ratio.
What should you consider before investing in stocks that may undergo a split?
The first thing to consider is the company’s P/E ratio. If the ratio is high, it may be an indication that the stock is overvalued and that a split is likely to happen.
You should also look at the company’s financials to see if it is in good shape overall. You can do this by checking it against our 10 Must-Have Stock Criteria, which you can download for free here.
Summary: Stock Splits Aren’t Anything To Worry Or Panic About
Generally speaking, stock splits aren’t anything to worry or panic about. In most cases, they are simply a sign that a company’s shares have become relatively expensive and the company is trying to make them more affordable for small investors.
However, there are a few things that you should keep in mind before investing in stocks that may undergo a split. First, look at the company’s P/E ratio to get an idea of whether the stock is overvalued. Second, check the company’s financials to make sure it is in good shape overall.
If you’re looking for more guidance on how to pick stocks that are likely to succeed, our free 10 Must-Have Stock Criteria can help. This checklist will show you what to look for before investing in any stock, and it’s a great starting point for anyone new to the world of investing.
Best of luck,