Understanding Stock Splits and How They Work

Understanding Stock Splits and How They Work
Point Editorial

Simply put, a stock split occurs when a corporation's board decides to increase the number of the company's distributed shares. Stockholders, in turn, receive more shares, which causes the stock's price to drop, making it more affordable to buy. 

Stock splits do not change the company's market capitalization, also known as its overall value. The most common stock split ratios are 2-for-1 and 3-for-1. 

Read on to learn about stock splits, the differences between stock splits and reverse splits, and the impact of both. 

How does a stock split work?

Also called a forward split, a stock split occurs when the price of a company's board decides its share price is too high. More affordable shares, in theory, will attract more shareholders. Shortly after a stock split, share prices will increase because of the laws of supply and demand. Stock splits usually indicate growth and therefore entice new investors. 

The most common split ratios are 2-for-1 and 3-for-1. Specifically, 2-for-1 ratios mean stockholders receive two additional shares for every one share they already own. The 3-for-1 ratio works the same way, except stockholders receive three additional shares.  

Splitting stocks increases a stock's liquidity on the market. Liquidity refers to how easily an asset, like a stock, converts into cash. Shares with a high degree of liquidity sell better. 

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Stock split versus reverse stock split

A reverse stock split occurs when a company reduces its shareholders' number of stocks, which, in turn, raises the stock's value. So, instead of a 3-for-1 split, for example, the reverse stock would be a 1-for-3 split. For every three shares initially owned, investors remain with one share. 

For example, Citigroup recently performed a reverse 1-for-10 split that caused share prices to go from less than $5 to $45.

How does a stock split affect you?

Understanding how a stock split affects you as a shareholder depends on the kind of split that occurs. Traditional stock splits boost your number of owned shares, while reverse splits decrease them. 

A stock split doesn't directly affect you if you already own shares. For first-time investors, stock splits are an opportunity to get into the game for a lower price. 

3 examples of stock splits 

Stock splits are a common phenomenon in the realm of economics. Many companies decide to split their stocks, usually with the intention of growing their overall worth in the long run.

In 2020, Apple split its shares at a 4-for-1 ratio. Prices dropped from $540 to $135, allowing a new wave of investors to purchase shares.

Tesla also split its shares in 2020, but at a 5-for-1 ratio. 

Finally, Alphabet, Google's parent company, split its shares at a 2-for-1 ratio in 2014.


Why do companies split stocks? 

Companies split their stocks so that share prices will drop and then rise again, which, in turn, renews investor interest. 

What should you expect when stocks split?

There are three things to keep in mind when it comes to stock splits. 

One: Announcement dates. Companies publicly declare when they will split their stocks. 

Two: Record dates. Current shareholders must own their current stocks by a specific deadline before receiving additional shares.  

Three: Effective dates. This is when the new shares will show up in your accounts after acquisition. 

What happens if you own shares that undergo a stock split? 

Again, as a shareholder, you'll have extra shares at a reduced price. Keep in mind that the overall value of the stock stays the same, so your investment won't be affected. 

Does a stock split impact my taxes? 

No. Additional shares are not taxable income. You only pay taxes when you sell the stock. 

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