If you’ve been investing for a while, you’ve probably had some experience with stock splits. In which case, this article probably isn’t for you. For the beginning investor, however, stock splits and reverse splits can be topics of considerable confusion.
Stock splits are really pretty simple to understand. When a stock price rises consistently over time, perhaps reaching triple digits, it can present a price barrier for many investors. Quite simply they can’t afford it. Still others who can afford the stock, and perhaps already own it, begin to get nervous, fearing it’s reached its peak and will soon be on its way back down. Obviously, for the companies whose stock has been doing well, this is a bad sign. They want their stock to continue flourishing. That’s where the stock split comes in.
Stock splits give shareholders more shares of stock at a lower price. For example, let’s say you own 10 shares of Acme Pinwheels stock at $100 and it splits two for one (you would get two shares for every one share you own). After the split you have 20 shares of Acme Pinwheels at $50 a share. Ultimately you still have the same amount of money invested in the company’s stock: $1,000. To think of it another way, stock splits are a lot like giving someone four quarters (or two 50 cent pieces) in exchange for a dollar bill.
Many investors tend to think (or hope) that after stock splits the stock will take off again. Although there is some truth to this, it doesn’t always work that way. Remember the reason many companies and corporations split their stock is to stimulate trading. By reducing the cost of one share of stock, more investors can afford more shares. Because investors are confident again about buying stock in the company, the stock price might rise. That is, in theory. After all, who’s to say a stock wouldn’t keep rising if it wasn’t split? Warren Buffet’s company, Berkshire Hathaway, had a stock price of nearly $130,000 per share as of April 2008. It has never split its stock, and yet it continues to grow.
Stocks can split in literally any combination: two for one, three for two, 10 for one, and so on. When you hear a stock is splitting three for two it simply means that investors are given three shares for every two shares that they own. The stock’s price would then be reduced by 33 percent.
Far less common than stock splits, reverse splits are just what their name implies: the opposite of stock splits. While in a regular stock split you’re increasing your amount of shares while the price of each share goes down, in a reverse split you exchange more shares for fewer and the price of the stock increases accordingly. But like stock splits your bottom line investment remains the same.
You might be asking yourself why a company would want to raise the price of its stock. The answer, sometimes, is to deter individual investors, which are often expensive and difficult to keep track of. Because in reverse stock splits the stock price increases, institutional investors such as mutual funds and firms (which often have minimum price requirements for stocks) may be given the ability to invest in the stock. When the stock does a reverse split, it may meet that requirement and more institutional investors can invest.