How Does a Stock Split Work?

by Leann Harms, Demand Media
    In a stock split, your number of shares increases but the overall value remains the same.

    In a stock split, your number of shares increases but the overall value remains the same.

    You’ve only just begun to invest in the stock market and already you’re learning there’s a lot to learn to be successful. Now suddenly you’re beginning to hear rumblings of a stock split and you’re left wondering what that even means and whether it’s a good thing or maybe you should get out while you can.

    Basics

    For all the complexities of the stock market, at least the terminology is relatively simple, especially when it comes to a stock split. Just imagine going to bed knowing you own 100 shares of a particular company and wake up to find you now own 200 shares. Well, that’s what happens with a stock split. While the number of shares you own has gone up, it’s important to know that the price also split. So if your 100 shares were worth $100 each, your 200 shares are now worth $50 each. You didn’t lose any money but you now own double the number of shares you originally owned.

    Ratios

    The example above illustrates what is known as a 2 for 1 or 2:1 stock split but this may not always be the case. The split ratio can vary but among the most common ratios are the 2:1, 3:1 and 3:2. So if you owned 100 shares, valued at $100 each in a 3:1 split, you would now own 300 shares at approximately $33.33 each. In a 3:2 split, you would now own 150 shares valued at approximately $66.66 each.

    Purpose

    The decision for a stock split is determined by a company’s board of directors and is usually based on a decision to increase the company’s available outstanding shares and make the price per share more affordable to investors without disrupting shareholders’ market value. It may seem a little pointless at first since a stock split won’t increase you’re overall value but consider the effect if the price per share goes up just $5 per share in the month following the split. Using the first example, with a 2:1 split you would have made $5 for each of your 200 shares, rather than the 100 shares you owned prior to the split. So instead of making $500, you have now made $1,000.

    Reverse Split

    Sometimes a company may decide that the price of their stock per share is so small it’s turning investors off so they will announce a reverse split. Let’s say you owned 20 shares of a company, valued at $25 each. In a reverse split you would now own 10 shares worth $50 each. Again, your overall market value isn’t affected.

    About the Author

    Based in South Florida, Leann Harms has been writing since 2008. Her design, technology, business and entertainment articles have appeared in "Design Trade" magazine and Web sites including eHow. Harms has a Bachelor of Arts in English from Florida Atlantic University.

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