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.
The Basics of a Stock Split
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.
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 of a Stock Split
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 your 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.
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.