Imagine finding out that the share price of one of your stocks is half what it was just the day before—but you own twice as many shares. Do you fly into a panic or pop a champagne cork? No need to do either. Your investment value has not changed. Stock splits are a common mechanism that companies use to encourage trading of their shares by adjusting the share price. Here’s how they work:
In a forward stock split, shareholders receive additional shares of stock, while the company simultaneously changes the value of each share so that there is no difference in the overall value.
Let’s say you own 100 shares of XYZ stock currently trading at $50 per share for a total investment of $5,000. If XYZ Company announces a 2-for-1 stock split, then you get two times the shares currently owned, or 100 additional shares, for a total of 200 shares. Simultaneously, the value of each share is cut in half to $25 per share. The end result is that the investment remains at $5,000. Stock splits are announced far in advance and the actual split and price adjustment occurs when the market is closed so as to not impact trading.
A reverse stock split would be the same process but backwards.
Consider the example above in reverse. If your 100 shares of XYZ stock trading at $50 per share go through a reverse 2-for-1 stock split, your share total would be reduced to 50 shares of stock, but the value of each share would be increased to $100 per share—still for a total investment value of $5,000.
What Good Are Stock Splits?
The purpose of a stock split is to increase the tradability of a stock. However, there are differing opinions on how and when such splits should happen, or if they are worthwhile at all. For example, Warren Buffett’s company Berkshire Hathaway has famously never split its stock. As a result it trades at an unwieldy price, recently hovering around $200,000 per share. Berkshire Hathaway, however, does also trade a B share the much more accessible $130-per-share range. Reasonable minds can differ on whether simply splitting the stock would have been an easier option than creating a new share class.
Other companies typically split their stock in one of two situations. Forward splits happen when a company’s share price rises to the point where the company thinks it impacts trading. Some experts feel that a share price that’s too high discourages smaller investors who may find a different stock rather than just buy a handful of shares. The company’s board of directors decides when to split a stock. There is no rule or law that dictates when, or if it happens. For example, IBM did a 2-for-1 stock split in both 1997 and 1999, when the share price was near $200 per share, but hasn’t done one since.
A reverse stock split happens when the company’s share price is too low. Sometimes a company must use a reverse split to ensure its share price remains above the minimum to trade on its exchange. For example, in 2009 AIG’s share price fell below $2 per share, putting it in danger of being delisted from the New York Stock Exchange. The company executed a 1-for-20 reverse stock split to get the share price up above $20.
The important thing to remember about stock splits is that nothing changes except for the share price. The investment retains the same value, the company’s market cap does not change, and even statistics such as earnings per share, adjusted to ensure consistency.
Academics, analysts, and traders argue back and forth on whether forward stock splits predict price growth or reverse stock splits predict further drops. But the average long-term investor may assume that a stock split neither improves nor worsens the current investment.
 IBM stock split data: http://www.ibm.com/investor/pdf/ibm_ir_stock_splits_2008.pdf