What is a Stock Split? Is it Good? Plus Real Examples!
Many investors, especially beginning investors, are surprised to receive a letter in the mail telling them of an impending stock split. The first question is usually, What is a stock split? The second question naturally follows: Is a stock split good?
If you’ve received such a letter or hear rumblings about a stock split pertaining to a security in your portfolio, it’s important to know what’s happening.
What is a Stock Split?
A stock split is aptly-named, because it involves a company splitting its existing shares. Usually, stock splits occur at a 1:2 ratio, where every existing share becomes two. However, stock splits can occur at other ratios. As the stock splits, so does its share price. Here’s an example:
Jim has 10 shares of XYZ company, at a current share price of $500 per share. XYZ company announces a 1:2 stock split. Jim’s portfolio now contains 20 shares of XYZ company, at a share price of $250 per share. The value of Jim’s holdings doesn’t change.
Is a Stock Split Good?
A stock split is generally a good thing. It means the company’s stock has been doing well. In fact, it has been doing well enough to reach a price that may dissuade general investors from buying it.
Many investors also feel better about their buying power when they can purchase more shares of a company at a lower price, rather than fewer at a higher price. Generally, a stock split has no real effect on investors, other than raising the number of total shares in their portfolio.
Reasons for a Stock Split
Why would a company do a stock split? Generally, it’s because its stock is doing too well! A great stock split example is Apple (Nasdaq: AAPL).
In 1994, Apple’s share price climbed over $700 per share! While that’s great for the company, it made it less attractive to investors with less buying power.
Apple voted to do a 1:7 stock split. This effectively brought the company’s per-share price down to $100. Investors were rewarded with 7x the shares of Apple, while the company was able to attract more investors at a lower share price.
What are the Advantages of a Stock Split?
Stock splits create liquidity. The more shares there are available to trade – called the stock’s “float” – the easier it is for investors to buy and sell them.
More stocks at a lower share price generally increases float. Fewer shares at a higher price reduces float, lowering liquidity. Liquidity is often attractive to day traders and short-term investors who rely on bigger float to trade shares rapidly throughout the new cycle.
Stock splits also allow companies to appeal to a wider range of investors without issuing new shares, which dilutes the existing share pool.
Beware Reverse Splits
While a stock split is generally good, there is a dark side: the reverse split. What is a reverse stock split? It’s when a company combines outstanding shares to raise the overall share price. It’s generally a sign of trouble.
Reverse splits indicate that a company’s stock isn’t performing well and is dropping to levels that might qualify it as a penny stock and even have it delisted from an exchange.
Reverse splits are also indicative that the company’s shares are diluted too much. Even more alarming, reverse splits usually occur in huge volumes, like 250:1 or 1,000:1.
Take a recent example like Helios and Matheson Analytics (OTC: HMNY), parent company of the popular MoviePass of 2018. The company ran into financial trouble and saw its share price begin to drop very quickly.
In July 2018, the company performed a 250:1 reverse split to salvage its share price, taking it from $0.09 to $22.50. Unfortunately, the stock fell back below $1 in just a week’s time.
Stock Splits are Part of the Market
In general, stock splits tend to indicate how well or how poorly a company is doing. Well-performing companies want to make their shares available to more people by lowering the per-share price – hence the split.
Poorly performing companies need to save face with an approachable share price, leading to reverse splits. As an investor, pay attention to which way the split goes to determine whether you should buy more or jump off the sinking ship!
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