- A stock split is the issue of new shares to existing shareholders in proportion to their current shareholding in a stock.
- A stock split happens whenever a company decides it needs to adjust its stock price, either up or down.
- A stock split is considered a good sign as it is a result of increasing stock price while a reverse stock split is just the opposite.
One morning you check your portfolio and start to panic: one of your stocks priced at $100 yesterday is now at $50. What could have possibly happened overnight to cause a stock to lose half its value? You check again and breathe a sigh of relief -- it was just a stock split.
A stock split happens whenever a company decides it needs to adjust its stock price, either up or down. It is simply changing the number of shares owned by each shareholder in an equal ratio for all, which, in turn, changes the price of the stock.
For example, if a stock is priced at $40/share with 1 million shares outstanding and it has a 2-for-1 split, then the stock will be priced at $20/share with 2 million shares outstanding. The value of the company hasn't changed, only the number of shares and the stock price.
Pre-split: $40 per share x 1 million shares = $40 million (company's market capitalization)
Post-split: $20 per share x 2 million shares = $40 million
From the shareholder's point of view, if you own 200 shares of a stock at $40/share, the value is $8,000. After a 2-for-1 stock split, you will have 400 shares at $20/share, also worth $8,000.
A stock split is simply changing the number of shares outstanding to change its price.
Why would a company want to do that? Companies want their stock prices to stay within a certain range.
If a stock price is too low, it can be de-listed from an exchange. The New York Stock Exchange requires all stocks to have an average daily closing price above $1 for the previous 30 days. The Nasdaq requires a $1 minimum share price and a market value of at least $1 million. Being de-listed can cause a company to lose a substantial portion of their market capitalization. It can also hurt a company's reputation, causing higher borrowing costs with banks and hurting sales from consumers. It is worth noting that if a stock price falls below $1 due to corporate fraud, the NYSE can suspend the stock from trading indefinitely.
On the other hand, if a stock price is too high, there are other negative consequences. Liquidity problems arise, meaning the stock trades fewer shares (volume) daily. It is harder to buy and sell the stock and wider price gaps exist between buyers and sellers. Marketability also becomes an issue: people who save $200/month must wait 3 months to buy one share of a stock that costs $600/share.
As a result, most companies want to keep their stocks in the $10-$150 price range (more or less). NYSE stocks are large-capitalization stocks that tend to be on the higher side of the range, whereas mid-cap and small-cap stocks tend to be on the lower end of the range.
If a stock price gets too high, the company can announce a stock split of any ratio it chooses to put the stock price where they want. The 2 for 1 stock split and 3 for 1 stock split are common. However, Netflix recently did a 7:1 stock split. The Netflix stock split was announced on June 24, 2015, and the split occurred 3 weeks later on July 14, 2015. Before the split, Netflix (NASDAQ:NFLX) traded in the $800/share range. After the split, it traded at $115/share. Someone with 100 shares of Netflix prior to July 14 now has 700 shares.
A stock split is considered to be a good sign. It means the stock price is going up due to growth in the company. It also means the company expects future growth. Stocks often enjoy a climb in price and sentiment shortly after a stock split.
When a stock price gets too low, the opposite can happen. A company will announce a reverse-split. Instead of more shares at a lower price, you get fewer shares at a higher price. 2000 shares of a $1 stock will turn into 200 shares of a $10 stock with a 1:10 reverse stock split. This is generally considered a bad sign, because it happens due to falling stock prices.
Knowing when your stock is going to split (or reverse-split) and what that means is a good thing. It just may prevent you from a panic attack some day when you check your stocks.
Disclaimer: This article is an original work by Gregg Killpack, of MarketTimingUniversity.com. I do not hold any positions in NFLX. I am not paid by an agency to create this content. This article is for educational purposes only. There are no warranties or representations that information provided herein will lead to successful investment strategies. Nothing in this material should be considered as an offer to buy or sell securities or an endorsement or recommendation to buy or sell securities.
Gregg Killpack, Market Timing University and their affiliates and employees are not licensed brokers, broker-dealers, market makers, or investment advisors. Nothing herein should be construed as investment advice. There is substantial risk of loss when trading or investing. A security's actual results could differ materially from forecasts due to certain inherent market risks. Past performance is not a guarantee of future results. Please consult a licensed broker or financial advisor before trading or investing.