Owning stocks can sometimes be a complex endeavour.
Picking what type of company to invest in, trying to decide if you’re getting in at a good price, picking between a small cap high growth stock or a dividend-paying blue-chip stock — these are all considerations you might come across on your journey.
Another thing you might need to know about is stock splits.
What's a stock split, and how does it work?
The quick answer is you’re getting more of the same, because a stock split is basically what it sounds like. A stock split increases the number of shares in a company.
Picture this. A pizzeria makes a delicious margherita pizza and they slice that pizza into six equal slices. (I’m totally convinced pizzas that have six slices are superior to those with eight slices, but that’s a debate for another time.)
Each slice is the equivalent of one share (stock) of a company. So, you buy two slices (two shares) and you’re pretty happy with your two slices.
Then, the pizzeria decides to revamp their slicing strategy. They decide on a split ratio of 2:1 (essentially, 2-for-1), which means for every one slice you own, you now have two. So, the entire pizza is now divided into twelve, but you still own one-third, as you have four slices (shares).
So, now you see how a stock split would work within a company.
By the way, it’s important to remember that the market capitalisation (i.e. value) of the company remains the same after a stock split; it’s just the number of shares on offer that increases. This means the value of each share is divided by the same ratio.
If you owned 500 shares at $1 each, and there was a stock split at a 2:1 ratio, you’d now own 1,000 shares, but at 50c each. The total value of your shares remains the same.
What’s the point of a stock split?
Stock splits can occur for a bunch of different reasons. Here’s a few:
1. The stock price is quite high
After the company’s stock price has risen over a period of time, a company may decide to do a stock split. Say the stock price started off at $1 and is now worth $10. The company could decide on a stock split ratio of 10:1.
So, if you originally had 10 shares, you would now have 100 shares. The overall value of your shares is still $100, but your individual shares are worth $1.
The general logic behind this is that people know the stock price was as high as $10 previously, so $1 might sound cheaper, and theoretically investors could push the stock price back up.
2. Liquidity
Another reason a company may want a stock split is due to liquidity. Providing 5, 10, 20 or 100 (or any other number) times the amount of stock to the market should mean that it’s easier to buy or sell the smaller parcels of stock.
Plus, people who might have felt as though the stock was more expensive previously could be more inclined to buy it at a lower price.
Additionally, some markets have minimum order requirements for, say, 100 shares. High share prices combined with a minimum required order can make buying in unaffordable for some investors. Splitting the shares results in a lower price, helping liquidity.
What's a reverse stock split?
In Australia, companies listed on the ASX can have their stock price go as low as 0.001c, or one-hundredth of a cent. When this occurs, the next increment the price can move up to is 0.002c, or double the current price, up until it reaches 10c.
This can be crippling for a stock and its price, so a company may decide to perform a reverse stock split. This creates the opposite scenario, meaning anyone invested would receive one stock for each 5, 10, 20 or 100 (or any other number the company decides on) they initially held.
Similarly, the price would be worth that multiple more. If the price was originally 0.001c and the company announced a 1:100 reverse stock split, the price would now be 10c and everyone would have 100 times fewer individual shares than they started with.
For anyone with an odd number of shares, reverse splits can mean that there are residual odd numbers of stock left over. If this is the case, the company will absorb paying each shareholder the equivalent amount of cash.
Usually, reverse stock splits are a bad sign. Companies typically use reverse splits after shares have fallen to boost the share price and therefore look like an ‘ordinary’ company.
Another reason is stock listing requirements; most stock exchanges require a minimum stock price for trading or the company could be delisted from the stock exchange.
The final word on stock splits
It’s important to remember a stock split can be done for any number of reasons, so if you see an announcement about an upcoming split (or reverse split), check out recent performance, how many shares are already outstanding, and any reasons given for the split.
As the pizza example above shows, no extra value is created. Therefore, understanding management’s reasons for making the split is key.
