Stock Splits

Stock splits refer to the process whereby a company increases its number of shares, reducing the per-share price of the stocks. The splitting is done following a significant rise in stock prices, making it difficult for investors to spend on them. However, reducing the costs makes purchasing the company's shares easier for traders, and they can continue choosing them for trade despite their rising value.

Though the shares split up, the total price of the stocks is the same when the price per share is added. Thus, an existing investor's pre-split price of stocks will remain the same post-split with an increased number of units.

• Stock splits are a process whereby a company increases the quantity of shares to reduce their prices, making them more accessible to retail investors.
• The publicly traded companies decide on splitting stocks in consultation with the board of directors.
• Forward and reverse splits are two broadly classified categories of stock splits.
• When companies split stocks, it indicates their positive growth and progress, leading to decreased share prices building an investor base as shares become more accessible.

Stock splits are a decision a company takes in consultation with its board of directors. The companies that make their shares publicly available to investors keep a particular number of units outstanding. They increase the outstanding shares, reducing the per-share amount for traders. Though the companies split the shares for a reason, they ensure the existing shareholders receive more units equalling their invested amount.

Primarily, companies announce a split when a long run-up is observed in their share prices. The share splits, as the process is also known, reduce the share price to make it affordable for retail investors. This, in turn, increases the investor base of the firms. Furthermore, the investors' trust in the company impacts the share prices positively, and the increase in the quantity of shares leads to their improved liquidity. This enhancement in liquidity makes the market more efficient, lowering the bid-ask spread.

For interested retail investors, shares become more accessible, while splits do not change anything for the existing shareholders except increased number of shares. On the contrary, future Earning Per Share (EPS) might reduce as the number of shares increases. In addition, share splits are tax neutral. There is no flow of money during share splits; hence there are no tax implications.

As the stocks split due to the rising prices of a company's share, the market players are aware of the firm's excellent performance. As a result, investors believe that the performance will continue to be better, and the company will remain in profits for the upcoming years. This, in turn, enhances the demand of the stocks and the prices simultaneously.

Stock splits occur in particular forms. Hence, they are classified based on those patterns, which fall under two broad categories – Forward/traditional/conventional and Reverse stock splits.

#1 - Forward Splits

Such splits are traditional and the most common types of share split. Here, a company increases the quantity of shares, thereby reducing the prices to a multiple that equals the unit share price. For example, Company A performs well, and its stock prices go up to $1000, making them unaffordable for an average retail investor. Then, to build its investor base, the firm splits the stocks into two and starts selling them at a reduced price, i.e., $500, to make them more accessible to traders.

The most commonly found forward split patterns are 2-for-1, 3-for-1, and 3-for-2. For example, in a 2-for-1 stock split, the investors receive two shares post-split for each share they owned before the split occurred. Similarly, for the rest two patterns, shareholders get three shares for every share and every two shares, respectively, after the split.

#2 - Reverse Splits

It is the opposite of a forward share split. In this case, companies reduce the volume of shares to increase the unit share price. They do this to secure their place in the market. The stock exchange that lists such companies' stocks delists them when their stock prices decrease beyond limits. Thus, these firms opt for reverse splits to retain their market position.

For example, if Company X reaches a point where its 100 shares trade at $50, it can opt for a 1-for-2 reverse split. The process can reduce the amount of shares to 50, and shareholders would receive one share for every two shares they own, increasing the prices to $100 per share.

Let us consider the following stock splits of 2021 and 2020 to understand how the principle works:

#1 - Stock Splits Nvidia

In July 2021, Nvidia split the stocks with no real long-term economic advantage in mind. It split the units in an unusual pattern, i.e., 4:1, different from the most widely adopted 2-for-1 pattern. It indicated one investor would own four shares post-split. This imposed a short-term bullish effect on the market. In addition, it made the NVDA stocks much more accessible to small retail investors as the prices reduced significantly.

#2 - Stock Splits Apple

Apple has split stocks, with the most recent one recorded in August 2020. It was the fifth time it split stock since 1980 as 4-for-1, offering four shares to shareholders for every share they owned. The shares were worth $499.23 each before the split, and post-split, it was reduced to $127. In June 2014, the tech giant split stock as 7-for-1, which reduced post-split price to $93 per share from $650 per share pre-split. However, the tech giant is soon set for more upcoming stock splits.

A bonus issue is similar to forward splits as both the terms involve an increase in the volume of shares and a decrease in the prices. In addition, these terms indicate how well the company is performing in the market. For example, when a company distributes shares from its reserves, it shows the positive financial health of that firm. Moreover, a share split occurs when its stock prices rise, indicating its strong market presence.

In case of a bonus issue, a company offers additional shares to existing investors without issuing dividends. Instead, the companies distribute these extra shares from the free reserves. On the contrary, a share split refers to splitting the existing company's shares.

So far as the pricing for the bonus issue is concerned, the face value of the shares is equal. In addition, the existing shareholders receive the shares as extra and free of cost. However, the stock splits lead to the reduction of face value in the same ratio.

This article is a guide to Stock Splits, its meaning & types. Here we explain how stock splits work and what happens when it occurs using examples from 2020-2021. You may also have a look at the following articles on Corporate Finance -

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