A stock split is a corporate action that alters the total number of a company’s outstanding shares while proportionally adjusting the share price, leaving the company’s overall market capitalization unchanged.
Understanding stock splits
A company initiates a stock split when its board of directors decides to either divide existing shares into multiple new shares or combine existing shares into fewer ones. This corporate action occurs on stock exchanges worldwide. A split that increases the number of shares is a forward split. A split that decreases the number of shares is a reverse split.
Elephants should note that a stock split does not change the total market capitalization of the company. The total value of the shares you hold remains exactly the same immediately following the split. The price per share automatically adjusts to offset the change in the number of outstanding shares.
Companies typically execute a forward split to lower the trading price of their stock. When a share price reaches a high nominal value, it becomes expensive for retail investors to buy whole shares. Reducing the price per share increases trading liquidity and makes the stock accessible to a wider pool of market participants.
A company performs a reverse split to increase its share price. This is a mechanical step used to maintain compliance with stock exchange listing requirements. Many international exchanges require a stock to maintain a minimum bid price to remain listed. A reverse split reduces the number of shares, which mechanically increases the price per share to satisfy these exchange rules.
Example
Imagine an agricultural firm called Savannah Peanuts Ltd. that trades on a major international exchange. The stock currently trades at $100 per share, and an Elephant investor owns 10 shares. The total investment is worth $1,000. The board of directors announces a 2-for-1 forward stock split. Following the split, the number of shares the Elephant owns doubles to 20 shares. At the exact same time, the stock price is cut in half to $50 per share. The Elephant still holds $1,000 worth of Savannah Peanuts Ltd. stock, but the investment is now spread across 20 shares instead of 10.