Why Stocks Split

If you have experience investing, you probably had some experience with stock splits. If this is the case, this article isn’t for you. For the beginning investor, however, stock splits and reverse splits can be topics of considerable confusion. The aim of this article is to alleviate that confusion.

What is a Stock Split?

Stock splits are really pretty simple to understand. When a stock rises consistently over the years, 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 it, and perhaps even own it, begin to get nervous, fearing it’s reached its peak and will soon be hit a decline. Obviously, for the companies whose stock has been doing well, this is a bad sign. They want their stock to continue to flourish. That’s where the stock split comes in.

Stock splits give shareholders more shares of stock and at a lower price. For example, if you own 10 shares of Acme Pinwheels stock at $100 and it splits 2 for 1: You get 2 shares for every 1 share you owned. After the split, you’d have 20 shares of Acme Pinwheels at $50 a share. Ultimately, the amount of money that you have invested in the company’s stock remains the same — $1000. To think of it another way, stock splits are a lot like giving someone four quarters 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 confidant again about buying stock in the company, the stock price may rise. That is to say, in theory.

After all, who’s to say a stock wouldn’t quit rising if it wasn’t split? Warren Buffet's company, Berkshire Hathaway, has a stock price that hovers around $80,000 per share. They’ve never split their stock, and yet it continues to grow.

Stocks can split in literally any combination — 2 for 1, 3 for 2, 10 for 1, et cetera. When you hear a stock is splitting 3 for 2 it simply means that investors are given 3 shares for every 2 shares that they own. The stock's price would then be reduced by 33%.

Reverse Splits

Far less common than stock splits are reverse splits. Luckily, they’re just as easy to understand. As their name implies, they’re the exact opposite of stock splits. Whereas in a regular stock split you increase 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 their 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 like mutual funds and firms — which often have minimum price requirements for stocks, e.g. $5 per share — 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 in them.