A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares. The stock split causes the price per share to decrease but increases the number of outstanding shares proportionately. Overall, the market capitalization of the company remains the same.
For example, in a 2-for-1 stock split, each existing share is divided into two shares. So if a company had 10 million outstanding shares priced at $100 each, after a 2-for-1 split the company would have 20 million shares outstanding priced at $50 each. The total market value remains at $1 billion in this example.
Stock splits make each share more affordable and increases liquidity in the market. A lower stock price appeals to smaller investors and stimulates trading activity. Companies will often split their stock when the price per share has risen to a level that is either too high or makes the shares difficult to trade. However, existing shareholders do not benefit or lose out from a stock split, because their percentage of ownership in the company and the total value of their investment remains the same.
Reasons Companies Split Their Stock
Companies may decide to split their stock for a variety of reasons. Two of the most common motivations are:
- To make the stock more affordable/attractive to small investors. By reducing the share price through a split, more investors can afford to buy individual shares. This can expand the company’s investor base and increase demand for shares. For example, a $400 stock price may be out of reach for many retail investors. But if the company does a 2-for-1 split to reduce the price to $200 per share, more individuals can purchase the stock. This also benefits the company by improving liquidity.
- To increase liquidity. Liquidity refers to how easy it is to buy or sell shares of a stock. Higher liquidity makes it easier for investors to execute trades. When there are more shares outstanding due to a split, it can facilitate larger trading volumes and smoother transactions. Investors know they can move in and out of the stock with minimal impact on the share price. Increased liquidity is attractive for both current and prospective shareholders.
How a Stock Split Works
A stock split increases the number of shares that are outstanding by issuing more shares to current shareholders. For example, in a 2-for-1 stock split, each shareholder gets an additional share for each share they already own, effectively doubling the number of shares they own.
The increased number of shares are distributed proportionally to existing shareholders based on the number of shares they held before the split. If a shareholder owned 100 shares before a 2-for-1 split, they would receive 100 additional shares after the split for a total of 200 shares.
While the number of shares outstanding increases, the total value of the shares remains the same. To balance this, the share price decreases proportionally. In a 2-for-1 split, the share price is halved. If a company’s stock was trading at $100 per share, after a 2-for-1 split the share price would be reduced to $50 per share.
The proportional decrease in share price restores the pre-split market capitalization of the company. If the company had 1 million shares outstanding at $100 per share for a market cap of $100 million, after a 2-for-1 split with 2 million shares at $50 per share, the market cap remains $100 million.
So a stock split changes the number and price of shares to make them more accessible and appealing to individual investors, but does not directly affect the company’s overall value. The increased liquidity from higher volume of shares trading often causes a short-term bump in the stock price after a split.
Reverse Stock Splits
A reverse stock split is the opposite of a forward stock split. Instead of increasing the number of shares and reducing the price, a reverse split decreases the number of shares outstanding and increases the share price proportionately.
For example, in a 1-for-2 reverse split, an investor who owns 200 shares valued at $5 each would end up with 100 shares valued at $10 per share. The company’s total market capitalization stays the same, but the number of shares is reduced and the share price increases.
Companies may pursue a reverse stock split to boost their stock price. If a stock price falls below certain levels, typically under $1, it can get delisted from major stock exchanges. A reverse split increases the share price and keeps it above the minimum requirements. Investors usually view reverse splits negatively since it indicates problems with the business.
The accounting for a reverse stock split is the same as a forward stock split. The par value per share stays the same while the number of shares decreases and the price increases proportionately. All per-share metrics like EPS also increase accordingly.
Stock Split vs Stock Dividend
A stock split and a stock dividend are two different corporate actions, although they both increase the number of shares outstanding and reduce the stock price proportionately. The key difference lies in how they are accounted for.
In a stock split, the number of shares outstanding increases but the total value of shares remains the same. For example, in a 2-for-1 split, each shareholder gets an additional share for each share held, so the number of shares doubles but each share is worth half as much. The company’s market capitalization stays the same.
A stock dividend issues new shares to existing shareholders. For example, a 5% stock dividend means existing shareholders get 5 additional shares for every 100 shares they own. The number of shares increases but, unlike a split, the share price decreases by the dividend amount. The company’s market capitalization increases by the value of the new shares issued.
So while both corporate actions have a similar effect by increasing liquidity and making the stock more accessible to retail investors, their accounting treatment and impact on market cap are different. Stock splits do not change the value owned by shareholders, while stock dividends do.
Accounting for Stock Splits
A stock split does not actually change the fundamentals or financial status of a company. The total value of the company’s shares remains the same. A company simply divides its existing shares into more shares. For example, in a 2-for-1 split, every existing share is doubled so the total number of outstanding shares doubles, but the price is halved.
Shareholder’s equity is not impacted by a stock split. A company’s market capitalization stays the same. For example, if a company has 1 million shares outstanding at $100 per share for a market cap of $100 million, a 2-for-1 split would result in 2 million shares at $50 per share, but still a $100 million market cap.
On the balance sheet, common stock shares and additional paid-in capital are adjusted to reflect the post-split number of shares outstanding. Retained earnings and total shareholder’s equity remains unchanged. The stock split transaction is purely a mathematical exercise.
