A stock split is when a firm reduces the price of its stock by dividing each existing outstanding shares into more than one share. Companies carry out a stock split to infuse liquidity. A stock split also makes shares more affordable for multiple investors who couldn't purchase the shares earlier due to relatively high prices.
The most common split ratios are 3-for1 or 2-for 1, which means that the shareholder will have three or two shares, respectively, for each share owned prior to the split.
What are stock splits?
Stock splits occur when a company chooses to split the existing shares of its stock into additional new shares to increase the stock’s liquidity. When a firm announces a stock split, the number of outstanding shares of that company rises, but the market capitalization remains the same. Although the existing shares are divided, the underlying value remains constant. As the number of outstanding shares rises, the stock price per share falls.
How does a stock split work?
Publicly-traded companies announce stock splits most of the time. The companies grow in value due to new product launches, acquisitions, or share repurchases. When the stock price has increased significantly, most publicly-traded companies will end up announcing a stock split to reduce the stock price and to make the shares more affordable.
For example, publicly-traded company A announces a 4-for-1 stock split. Prior to the stock split, you held 100 shares priced at $100 each for a total value of $10,000. After the stock split, your total investment value remains constant at $10,000. The stock price is marked down by the divisor of the split. So, a $100 stock becomes a $25 stock after the 4-for-1 split. After the split, you own 400 shares priced at $25 each, so the total investment value is still constant at $10,000.
Types of stock splits
Traditional stock splits like 2-for-1, 3-for-1, and 3-for-2 are the most frequent forms of stock splits. In a 2-for-1 split, a stockholder gets two shares after the split for each share held prior to the split. In a 3-for-1 split, a stockholder gets three shares for each share, while a stockholder gets three shares for every two in a 3-for-2 stock split.
One example is the electric car company Tesla. On Aug. 31, Tesla split its stock 5-for-1, which suggests that investors who held one share of the stock now own five shares. Before the split, each Tesla share cost approximately $2,213 on the basis of the closing price on Aug. 28. After the split, the shares were trading at approximately $442 per share.
Another example is the tech giant Apple. On Aug. 31, Apple split its stock 4-for-1. Before the split, each Apple share cost approximately $499.23 on the basis of the closing price on Aug. 28. After the split, the shares were trading at approximately $127 per share.
Pros and cons of stock splits
If the price of a stock increases into the hundreds of dollars per share, it tends to decrease the stock's trading volume. A stock split can improve liquidity in the market and make the share more affordable for retail investors. Also, a stock split can increase volatility in the market because more investors may decide to buy the stock.