What Is A Stock Split? 

A stock split is a restructuring of a company’s existing share capital wherein existing equity holders receive additional shares, in order to reduce the stock’s share price while maintaining the proportionate dollar value of their shares. This “split” is typically structured in either a 2-for-1, 3-for-2, or 3-for-1 ratio, meaning that for every one share of stock held prior to the split, the stockholder will receive two for each (in the case of a 2-for-1), three for every two (in the case of a 3-for-2), or three for every one (in the case of a 3-for-1) after the split. It is important to note that stock splits simply involve the issuance of additional shares to existing shareholders; no new money is taken into the company by the shareholders in this process.

Understanding Stock Splits 

Before delving into the specifics of a stock split, it is important to understand the mechanics of share issuance and the various form of equity capital that can exist. Equity capital is the capital held by a company’s shareholders. It is represented as a combination of common stock, preferred stock, and retained earnings (in the form of paid-in surplus). Common stock is the form of equity capital owned by ordinary shareholders, generally possessing voting rights and a residual claim on the assets of the company; preferred stock is a form of equity capital that generally does not possess voting rights but has a higher claim on the assets of the company than common stock; both of these types of equity capital are held by a company’s shareholders.

Purpose of Stock Splits 

The purpose of a stock split is to reduce the price of the existing shares without changing their proportionate dollar value. When a company splits its stock, the shareholder may end up holding fewer shares of the company but at a substantially lower price; however, the overall value of the shares stayed the same prior to and post-split. Additionally, a stock split can also help to increase liquidity in a security by decreasing the cost per share and potentially increasing the number of shares that are traded daily. This, in turn, can potentially increase the number of potential shareholders, thus leading to a greater trading volume.

Types of Stock Splits 

Stock splits typically come in three different forms: a 2-for-1 splits, a 3-for-2 split, or a 3-for-1 split. As the names imply, in a 2-for-1 split, an investor holds one share of the company’s common stock, and for every one share held, the investor will receive an additional share; in a 3-for-2 split, investors will receive three shares of the company’s common stock for every two shares held; and in a 3-for-1 split, investors will receive three shares of the company’s common stock for every one share held.

Advantages of Stock Splits 

Stock splits can offer a number of advantages to a company and its shareholders. For one, as previously mentioned, they can help to increase the liquidity of a security, allowing more people to invest in the company and driving up demand. In addition, stock splits can also help to make a company look “cheaper” on an individual basis. This increased price affordability, in turn, may increase the number of retail investors participating in the market and boost trading volume, which can increase the perceived value of the stock and allow the company to access new capital through the sale of new shares.

Disadvantages of Stock Splits 

Despite the advantages of stock splits, there are also several potential disadvantages. For one, if the shares of a company that has undergone a split remain stagnant or decrease in value, the split may be seen as a sign of desperation and could lead to a decrease in investor confidence. Additionally, if the company’s share price had already been too low prior to the split, the company may not see the desired increase in liquidity or demand. Finally, the increased number of shares can dilute the value of the stock overall and drag down the EPS (earnings per share) of the company, which can impact its ability to raise capital in the future.

Stock splits are an often-used tool by companies to reduce their per-share pricing while maintaining a consistent proportionate dollar value for their equity. While stock splits can offer many advantages, such as increased liquidity and the ability to capture new investors, it is important to note that they can also bring about potential drawbacks, such as a decrease in the EPS, that must be taken into consideration before undertaking a split.