The term “stock split”, also known as a “stock divide”, refers to a process that increases the total number of equity shares in a company. While this creates more shares, the total price of shares is altered in such a way that the market capitalization of the company stays constant after the split. Essentially, a stock split happens when a company’s board of directors decides to boost the number of shares that are outstanding by issuing more shares to current shareholders.
As an example, consider an investor who owns 10 shares of Company LMNOP, at $20 per share. In the event of a 2-1 stock split, he or she would then own 20 shares worth $10 per share. As you can readily see, the total worth of the stocks owned by the investor remains the same, at $200. This may raise the question of why a company would consider a stock split if the amount of money remains the same.
The reason is because more stocks can equal more liquidity for the company. In addition, companies may also be of the mindset that their stock must remain less expensive, so that more potential investors can consider purchasing it. Theoretically, however, the increase in the number of shares, and the potential buying and selling, can also make the shares more unpredictable on the market.
Some companies have become well known for their policies of not splitting stocks. For example, Berkshire Hathaway’s stocks sold for $8 per share in the 1960’s, but the same stocks have soared as high as $150,000 per share! This type of situation certainly can create a very constant foundation of shareholders.
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The above explanation considers a normal stock split. The term “reverse stock split” refers to the exact opposite. If a company falls on hard times and the share price drops to very low levels the board of directors my want the stock price up. There are several reasons for this; investors perceive a very low priced stock as less desirable, exchanges may only list stocks selling over certain prices, etc. In this case the board cuts the number of shares perhaps in half which should result in a doubling of the share price. Usually investors perceive the company is having problems so the actual share price may start trading at somewhat less than double.
Hope this helps.
Steve Wasylkowski