What is a stock split in the first place? You may have heard of it in the stock market many times before but never had the chance to look it up. You will know a lot about it after reading this article. The Business Dictionary defines it as a
Division of already issued (outstanding) shares of a firm into a larger number of shares, to make them more affordable and thus improve their marketability while maintaining the current stockholders‘ proportional ownership of the firm.
Companies do not go through this hassle for no reason; in fact, It’s always done for their best interest although shareholders do benefit from it. There are two most common split ratios: 2 for 1 and 3 for 1. When you buy one share you receive two instead, or when you buy one share you get three (2-for-1, 3-for-1 respectively).
Companies do stock splits to reduce their price per share.This is a good strategy for companies that are very pricey which causes traders not wanting to buy their shares. Because most stock investors prefer to invest into inexpensive stocks. Once a stock split has been performed there’s always an attraction of buyers followed due to the increase in the number of shares they will acquire. I would say it’s a win-win situation for both the companies and shares buyers.
Although a stock split decreases the price per share it does not actually decrease the value of the stock. In order words, the price of the stock remain the same if you would do the calculation. For example, a company’s stock is selling at $100 a share, they decide to perform a stock split. If they had 20 million shares outstanding selling at $100 per share, it would be a total of 2 billion dollars. After a 2 for 1 split they should have 40 million shares available at a price of $50 per share, which should still give a grand total of 2 billion dollars.
A stock split 2 for 1 attracts small investors into the company. But many companies don’t like when they are trading too low, talking mostly about the blue chip stocks.
Those companies prefer to go with the reverse stock split method. This split is just the opposite of the first one you’ve just read about. In a reverse stock split the company would reduce their number of shares while increasing the share price proportionally. Let’s say company XYZ is undergoing a reverse stock split and you happen to owned 10,000 shares from this company. After a 1 for 10 reverse split you should have 1,000 shares in your portfolio.
Similarly to the first split, there’s no effect on the value of the stock in a reverse split. This split is done to increase the price of the stock which will cause the small investors to sell their shares, thus attracting those who have more money.
I know this could be confusing, but this is how it works. Actually many other strategies in the stock market are confusing, but we do have to try to understand them if we plan on becoming great stock traders.