There are two types of stock splits that you may encounter with your investments. Here’s what you should worry about – and what you can ignore.
Hold onto your hats. We’re going to get a little math-y here. Not too much! But to discuss the two types of stock splits you may come across, we need to do a little division and consolidation. Nothing complicated. We haven’t had enough coffee yet, so we’ll keep it simple.
First, we should point out the neither of these types of stock splits actually change the value of a company or the shares you hold. As a matter of fact, on paper, there’s no real financial difference at all. Yet, stock splits can have advantages and disadvantages, depending on the details.
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What these two types of stock splits are (and what they mean to investors)
A stock split merely changes the number of available shares of a company. It does not increase or decrease the dollar value of the company or your holdings. If you have $1,000 invested in a company, that could be in the form of 10 shares valued at $100 each. It could be two shares valued at $500 each. Or four shares at $250. Or even 2,000 shares valued at 50 cents each. No matter which variation of these you have, you still have a $1,000 investment.
So what are forward and reverse stock splits? In a forward stock split, a company increases the number of shares available. Let’s go with our $1,000 investment example. You own 10 shares at $100, and the company announces a 2-for-1 stock split. You now own 20 shares valued at $50 each. You’ve neither gained nor lost money, but you did acquire more shares.
A reverse stock split is the opposite of that. A reverse stock split will reduce the number of outstanding shares. Let’s say you buy 20 shares of a company at $50 each. The company announces a 1-for-2 stock split, so you now own 10 shares valued at $100 each. Just like above, we’re still working with that same $1,000; it’s just divided up differently.
You’re probably wondering why a business would go through either of these types of stock splits if it doesn’t change the company’s value.
There is one very significant advantage of a forward stock split. Because this kind of split lowers the price per share, it can be a good strategy for bringing in new investors who could not previously afford or want to pay higher prices per share. Making shares more accessible means more investors are buying in, which, as you know, does increase the value of a company.
So, where does that leave a reverse stock split? There are some good reasons a company might take this approach. One primary reason is that many exchanges require a minimum stock price. Consolidating your stocks can increase the price per share, allowing a company to remain listed on an exchange.
That price per share increase can also attract more investors – especially institutional investors. To use our example above, 2,000 stocks selling at 50 cents per share aren’t going to seem as valuable as 100 shares would at $10 each. Even though, again, we haven’t changed the total dollar amount of any investment or company value.
It is true that a reverse stock split could be a way to hide a sinking share price and squeeze some more life out of a stock. However, that’s the sort of information you need to look at before you invest in any company, not just those that have utilized either of these types of stock splits.
Ultimately, there’s no real need to worry about stock splits. What’s more important is to look beyond the split itself and examine the reasons behind that split.
Have you held any stocks that split? What was the outcome for your shares?
