Why do stocks split?
Most companies split their stock to keep the price attractive to individual investors. After a stock split, there are more shares outstanding but the market value remains the same. For example, a 2-for-1 stock split is like getting two nickels for a dime.
Say an investor owns 200 shares of a stock that's trading at $120. The company announces a 3-for-1 stock split. That means when the split goes into effect, the investor will own 600 shares. But the shares will trade at $40. The value is the same ($24,000) but the price per share is lower.
Small investors usually buy stock in round lots — 100 shares or multiples of 100. Most splits — whether 2-for-1, 3-for-2, 4-for-3 or whatever — appear aimed at keeping the price in the $30 to $50 range. This allows a small investor to still buy a round lot for $5,000 or less.
By making their stock attractive to individual investors, companies help ensure that their shareholder base is as wide as possible. The more shareholders, the broader the company's support and the more exposure its business and products have both in the local community and across the country. A large shareholder base also helps deter small groups of shareholders from gaining control or exerting too much influence.
Many investors welcome splits. They believe they're getting more for their money. A stock split also might signal that a company is experiencing healthy growth. That's why its stock price keeps rising, necessitating a split.
One thing to watch out for is when a company has numerous stock splits within a short period of time. This could signal that the company's stock has reached the end of its growth run.
A cousin of the standard stock split is the reverse split. This occurs when a company exchanges multiple shares for a single new share. For example, if a stock is selling for $1, the company could do a reverse split and exchange two old shares for one new share priced at $2. Of course, the market ultimately decides if the new shares are really worth $2, just as it set the old share price at $1.
Why would a company do a reverse split? In most cases, the stock's price has fallen dramatically and the company wants to make its shares look more valuable. The reverse split may also be needed to raise the stock's price to the minimum needed for listing on an exchange. Either way, reverse splits are generally a bad sign and a warning to investors to be extra cautious.