All publically traded companies offer a limited number of stocks that are outstanding in the stock market. In doing so, companies are aiding in the creation of value because they are making their shares a scarce resource. Generally, the scarcer something is, the more value it holds. However, what happens when a company’s stock becomes too valuable? Can that happen? Interestingly, yes, a company can see its share price surge to a level that is deemed too high for potential investors, or just significantly higher than other companies in their sector. What can be done to combat such a scenario? Enter, the stock split.
Simply put, a stock split is a decision made by a company’s board of directors to increase the number of shares that are outstanding in the market by issuing more shares to current stockholders. For instance, a company could issue a 3-for-1 split meaning that two additional shares are given to each stockholder for each share they own. Therefore, if the company had 1 million shares outstanding prior to the split, it would have 3 million shares outstanding following a 3-for-1 split. Further, two of the main motivations behind a stock split is driving the price of each share down in order to attract new investors, while also increasing the liquidity of the stock. Additionally, it is important to note that even though shares are more affordable following a stock split, the underlying value of the company has not changed.
Although, as mentioned above, there is a decrease in share price during the stock split, there is often a considerable price increase soon thereafter. This is because investors with smaller amounts of capital then find the stock more attractive — since it is cheaper — and they cause a boost in demand. Moreover, and as you have likely come to learn through understanding basic economic theory, a boost in demand leads to a decrease in supply and an increase in price. Similarly, it is also possible that demand for a company’s stock will increase because investors view the stock split as a signal of growth and confidence that the share price will continue to rise in the future. In essence, if the company was signaling to the market that it was not anticipating continued growth then it likely would not have executed a stock split.
In contrast to traditional stock splits, companies sometimes decide to conduct a reverse split. This method is most commonly utilized when companies have low share prices and are hoping to increase them in an effort to gain more respect in the market and, in some instances, avoid being delisted. Unfortunately for some companies, it is not uncommon for stock exchanges to delist stocks if they fall below a determined price per share. With this in mind, a company could execute a reverse 1-for-3 stock split meaning that every three shares owned will be combined into one share. To further elaborate, if a company had 30 million shares outstanding trading at $1 per share, following the reverse split there would be 10 million shares outstanding trading at $3 per share. Notice that although the number of shares has been reduced by a factor of three, the underlying value of the company remains constant at $30 million. Finally, a reverse stock split can also be used in some cases to reduce volatility as many investors find that more expensive stocks tend to be less volatile.
Ultimately, as an investor who strives to make the most knowledgeable decisions possible, it is important for you to continue to discover new potential opportunities and how to take advantage of them. While no opportunity is perfect and all investments involve taking on some type of financial risk, there are certainly ways in which you can better control the amount of risk you incur. Accordingly, I hope this article has served its purpose as an introduction to the concept of stock splits and I urge you to continue doing your own independent research!