If you have individual stocks in your portfolio, or if you’re just a casual observer of the market, you’ve probably heard the term “stock split” before. But what exactly is a stock split?
With a stock split, the management of a company decides to increase the number of outstanding shares available to the public. More often than not, companies execute a 2-for-1 stock split, although 3-for-2 splits are also common. Say you own one share of a stock worth $20. After a 2-for-1 split, you will own 2 shares that are now valued at $1 per share.
There are a number of strategic reasons companies decide to split their stock. These include:
Increased liquidity. If management wants to interest investors but feels the company’s shares are too expensive, a stock split will decrease the price and make it more accessible to small investors, increasing its “liquidity,” or how easily it trades.
- Hostile takeover. If management holds a small percentage of the outstanding shares, making more stock available through a split can decrease the chances of a hostile takeover.
- Change of stock market. If a small company whose shares are listed on the Nasdaq wants to list its stock on another exchange, it has to have a higher number of shares outstanding. The New York Stock Exchange, for example, requires that companies have a minimum of 1.1 million shares and at least 2,000 shareholders before it will list the stock.
- Acquisition purposes. If a larger company wants to buy another with minimal cash or debt, a stock split will produce additional shares, a powerful inducement for the shareholders and directors of the company being taken over.
There is also the reverse split, the opposite of a regular stock split. In this case, say a 1-for-2 split, the number of outstanding shares decreases while the stock price increases. For example, if a company’s shares are trading at $50, they will be worth $100 once the reverse split is executed. One of the most common reasons for a reverse split is that management feels the stock price is too low to attract institutional investors, such as mutual funds and pension funds.
But don’t just buy a stock because it’s splitting its shares. Conduct a thorough research and see if the company is a good long-term buy or not.