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Stock Split

An offer of more shares to existing shareholders

What is a Stock Split?

Publicly-traded companies all have a given number of outstanding shares or shares of stock in their company that has been purchased by and issued to investors. A stock split is a decision by the company to increase the number of outstanding shares available to them by extending the offer for more shares to its existing shareholders.

 

Stock Split - Market Ticker Prices Double Shares

 

More About Stock Splits

When a company decides to split its stock, it determines the ratio for the split. There are a variety of combination ratios open to the company. However, the most common are 2-for-1, 3-for-1, and 3-for-2 splits.

To understand the concept better, let’s look at an example:

Company A has decided to split their stock and has settled on the, inarguably, most common split ratio: 2-for-1. In this example, shareholders who’ve already purchased and been issued shares of Company A’s stock would be given another share for every stock they already own. In such a scenario, let’s assume that Company A has 30 million outstanding shares. After the 2-for-1 stock split, they’ll have 60 million. However, this also means that the value of each share decreases by 50%.

Stock splits, as our example shows, increase Company A’s total number of shares outstanding, but, with the 2-for-1 ratio, makes two shares the same value as one share would have been before the split. Regardless, Company A’s market capitalization isn’t affected by this because the total market value of the outstanding shares is still equal to what it was before the split.

 

Reasons for Stock Splits

Perhaps the most important question to ask, after fully understanding the nature of a stock split, is why would a company want to double or triple their stock shares if each share will be worthless and their market capitalization won’t be affected?

There are a number of reasons for stock splits. However, there are two that are most common. The first has to do with perceived company liquidity. With each share’s price dropping a certain percentage – depending on the ratio that the company decides to use – investors tend to see the company’s stock as more affordable, and therefore may be more likely to buy shares. The lower the share price, the less risky the stock seems.

A stock split makes the stock more affordable for more investors and thus can be used to draw in new investors who may have been reluctant or simply unable to purchase the stock at its higher, pre-split price.

The move is a useful strategy when a company’s stock price rises to the level that prices many investors out or when a company’s stock price has risen significantly higher than that of its competitors’ stock.

 

Key Takeaway

Stock splits can be a lucrative and important step for companies looking to draw in more investors. It is particularly true for companies that are experiencing rapid growth. A company that is growing or believes it will grow may choose to split their stock, giving a positive indication of growth to investors, which ultimately helps it grow in the long run.

 

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Common Stock
  • Cost of Preferred Stock
  • Dilutive Securities
  • Share Capital

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