What is a Stock Split?
A stock split, or stock divide, is a means for increasing the number of oustanding shares of a company. Based on the ratio, the share price will decline and the investor will receive proportionally more shares. There is no effect in terms of the market capitalization of the company. For example, if GE issued a 2 for 1 stock split when the stock was $20, an investor who owned 1,000 shares will now own 2,000 shares worth a price of $10. The company can split the stock at any ratio they please but 2 for 1 is most common.
Why Do Companies Split their Stock?
Many investors shy away from higher priced stocks for psychological reasons. They naturally believe that they can make more money on a cheaper stock. That is one reason that companies opt in for a stock split, to inject liquidity into the market for their stock. This action is typically taken by companies whose share prices have fallen to levels where they are in jeapardy of being de-listed from the stock exchange that they are traded on. Other companies will participate in a reverse split to attract more liquidity. There are many mutual funds and hedge funds and even personal investors who will not trade stocks below a certain threshold; $5, for example.
Additionally, management may split a stock to bring it down to prices more comparable to their competitors. Management may also elect to split a stock when the stock is racing to new highs as analyst upgrades are coming in and there is bullish undertone in the market for this stock. The idea is that the market is so bullish for this stock that splitting it will just make more money as it continues to climb.
Reverse Stock Split
A reverse stock split does exactly the opposite of a stock split; it decreases the number of shares in float and increases the price of the stock. While it will have no effect on the value of the company, it is typically not a good sign to see.
One byproduct of a reverse split is that a shareholder may be paid out in cash upon the split if they do not hold enough shares to be made whole if the split occurs. For example, if an investor holds 75 shares of a stock which has been reversed at a 1:100 ratio, the company will just pay out the investor the cash value of the shares since they cannot give them a full share.