A stock or share split occurs when a company 'splits' its shares to increase the number of shares on issue. Although the number of shares in the company rises, the company's overall value doesn't change.
Companies may decide to conduct a stock split to reduce their share price and increase the liquidity of their shares. A company can also undertake a reverse stock split to consolidate several shares into one. This serves to increase the value of individual shares.
How does a share split work?
A stock split occurs when a company increases the number of shares it has on issue by splitting shares into multiples. This is a forward stock split and does not change market capitalisation.
Let's assume a company has two shares issued worth $100 each. If it conducts a two-for-one stock split, it will have four shares on issue, each worth $50. Notably, a stock split does not change the total value of the company's issued shares or the proportion of the company held by each shareholder.
If two different people held the shares in this example, they would each still hold 50% of the company after the split. A stock split can enhance liquidity because more shares are available to be traded. It can also make individual shares more affordable to investors.
Companies can also conduct reverse stock splits, where they reduce the number of shares on issue. In a two-for-one reverse split, you would receive one share for every two shares you currently own. If you held 50 shares in a company, you would have 25 shares after the reverse share split.
Reverse share splits are not usually great news for investors, as they often occur after a large fall in the share price. Consolidating the number of shares on issue bolsters the share price as the company's value is spread across fewer shares.
What is a forward split?
A forward stock split divides a company's existing shares into multiple shares. Two-for-one and three-for-one share splits are commonly used, but any ratio can be used. A forward stock split increases the number of shares on issue, but the price of each share will reduce proportionately.
The market capitalisation of the company remains the same. If a company with one share on issue worth $150 conducted a three-for-one stock split, it would end up with three shares on issue worth $50 each. Its market capitalisation would be unchanged at 3 x $50 = $150.
Why do companies choose to split their shares?
Investors can be more comfortable buying 100 shares of a company at $50 a share than one share at $5000. So listed companies that have seen their share prices rise substantially can use a stock split to reduce the share price.
The higher number of shares on issue after the split can also enhance liquidity. This will reduce the buy-sell spread, meaning buyers and sellers can trade the shares without impacting the share price too significantly.
Although forward stock splits reduce the share price of a company in theory, in reality, they can attract renewed investor interest in a company. This in itself can see an increase in the share price. Over time, it may return to its previous level, especially if the company keeps growing.
Some companies, such as Wal-Mart Stores, Inc, have split their stock many times. Other well-known overseas companies that have conducted share splits include Alphabet, Tesla Inc and Nvidia Corporation.
Stock splits are less common on the ASX than in the United States, although a number of ASX-listed companies have conducted reverse share splits, including Orora Ltd (ASX: ORA) and Viva Energy Group Ltd (ASX: VEA).
Reverse share splits or share consolidations reduce the number of shares on issue. This results in a proportionate increase in the share price. Shares on the ASX can trade for as little as a cent, which can be unattractive to investors and lead to volatility.
A reverse share split can adjust the share price to a more attractive level. Reducing the number of shares on issue also serves to increase earnings per share (EPS) and can help reduce share price volatility.
What should you expect when stocks divide?
Companies that wish to conduct a share split must announce their plans to the market. This may be done at a general meeting. A forward or reverse stock split may be accompanied by other corporate actions, such as a capital return to shareholders or special dividend payment. Notice of these actions can be contained in the notice of the general meeting.
There are key dates to be aware of when a stock split occurs. The first is the announcement date when the company lets investors know its plans.
This will include the key details investors need to know, such as the record and effective dates. The record date is when investors need to hold shares to receive shares in the stock split or have their shares consolidated in a reverse split. The effective date is when shares begin trading on a split-adjusted basis, and holdings will be adjusted in investors' brokerage accounts.
For existing shareholders, a forward stock split will result in them receiving an additional allocation of shares in proportion to their holding. It may also increase the interest of investors who do not currently hold shares in the company.
After all, if you have been considering an expensive share and it suddenly becomes significantly cheaper, it may be tempting to buy. For this reason, stock splits are sometimes considered a promising sign for the share price, although evidence is mixed. If you are considering buying shares due to a share split, make sure the purchase is in line with your investment objectives, and you have done your research.
Recent examples
Alphabet announced a high-profile 20-to-1 stock split in early 2022, the company's first in eight years. At the time, Alphabet shares were trading at around US$2,700, so the split would result in a new share price of around $135. The lower price of shares is likely to pique the interest of a new class of investors and improve liquidity. With more shares on issue, more shares will change hands each time a trade is made.
Other companies that announced stock splits recently include Shopify Inc and Amazon.com Inc, which announced 10-to-1 and 20-for-1 stock splits, respectively.
Foolish takeaway
Forward stock splits involve dividing shares, resulting in more shares on issue. Reverse stock splits involve consolidating shares, so fewer shares are on issue. Either way, stock splits can make share prices more attractive to investors and improve liquidity.
Investors often view forward stock splits more favourably due to their ability to attract new classes of investors and because they are often conducted after share price rises.
Reverse share splits, or share consolidations, are generally viewed less favourably as they can occur after a decline in the share price. Forward stock splits are more common in the United States than in Australia, as even the costliest shares on the ASX were worth less than $300 in June 2022. On the other hand, shares in Berkshire Hathaway were trading at more than US$500,000 during the same period.
