When you invest in stocks, your portfolio will sometimes be impacted by events outside your control. One reason for this is that companies can take corporate actions: decisions that impact a stock and, as a result, all shareholders.
One of the most common corporate actions is a stock split. For those unfamiliar, it can be quite alarming; you could wake up one morning to find that you hold more – or fewer – shares than you did the night before. This is because stock splits change the total number of shares that investors own. In a ‘forward stock split,’ your shares multiply. In a ‘reverse stock split,’ they merge together, leaving you with fewer shares overall.
The most important thing to remember is that – no matter what your new number of shares may be – the overall value of your investment will stay the same. When a stock split occurs, the number of shares changes, but the price of the stock also changes to ensure there is no shift in monetary value. In other words, the stock split will not change the value of your stock position.
Forward Stock Split
Let’s look at a simple example: A company might decide to have a 2-for-1 forward stock split. Every existing share would split into two shares. If you held ten shares in this company before the split, you’d have twenty afterwards.
The number of shares you own would change, but the overall value of your investment would stay the same – which means the stock price would have to change in the split. If the stock price was $80 before the split, it would be $40 afterwards. There would be twice as many shares, each worth half the price.
If you held ten shares at $80 per share before the split, your investment would be worth $800. After the split, you’d hold twenty shares at $40 per share. If you do the math, that’s still an $800 investment.
Aside from fun mental math gymnastics, there are reasons why a company may do this. Most commonly, companies are trying to make their stock more affordable. If a stock price is sitting around $1,000 per share, it may be inaccessible for investors with smaller balances. Lowering the price through a 2-for-1 or 4-for-1 stock split would make the stock more attractive to investors.
Forward stock splits (also just called ‘stock splits’) tend to be a sign of good company health, as they often occur after a stock price has surged. In many cases, companies react to upward momentum by bringing the price back down to a more affordable level. This bodes well – more shares for investors, and hopefully further gains!
Reverse Stock Split
Reverse stock splits are the exact opposite of forward stock splits, in terms of how they work: The number of shares reduces, and the stock price increases.
Let’s say you have 1,000 shares of a stock trading at $0.50 per share. If the stock were to have a 1-for-10 reverse stock split, you’d be left with 100 shares at $5 each. As with a forward stock split, the total value of your investment would remain the same. But, this time, you’d be left with fewer shares than you had before.
Reverse stock splits are also the opposite of forward stock splits in terms of what they tell us about company health, as they typically happen to companies declining in value.
Much like forward stock splits, companies implement reverse stock splits to appear more attractive to investors. But, rather than making themselves more affordable, companies are often trying to prevent their low stock prices from scaring off investors. When a stock falls below $5, it’s widely considered a ‘penny stock,’ which many investors prefer to avoid. As well, some stock exchanges have a minimum stock price as a listing requirement. Reverse stock splits can help declining companies stay above this threshold.
Where did my shares go?
Enough reverse stock splits can completely erase your position in a stock. For instance, let’s say you purchased 100 shares of a company. Due to poor performance, the stock price has been falling for several years, and the company has announced multiple reverse stock splits since your initial purchase. The first was a 1-for-50, which left you with just two shares. The second was a 1-for-10.
You’ve probably spotted the problem by now. You’d need ten shares before the split – eight more than you had – just to have one share afterwards. Your position now is only worth a fifth of a share. To solve this, the company simply provides you with the cash equivalent of your current position. This is called getting ‘cash in lieu.’
In this example, you’re left with zero shares, plus a little bit of cash. This isn’t ideal, but – assuming the company never recovers – it isn’t terrible either. At least you get to leave with some money. But, if the company does bounce back, and the stock price rises substantially after the split, that’s your worst-case scenario. Your position has been completely erased, and you don’t benefit from the stock’s recovery at all.
Retroactive price adjustment
You might be wondering: If stock splits happen all the time, how can we judge the performance of a company based on its historical stock prices? If a company is on an upward trajectory, then the stock price suddenly cuts in half due to a split, will it look like the value of the company has cratered overnight?
The short answer is: no, it won’t. Many data providers – including Google and Yahoo Finance – will adjust all historical prices to account for stock splits. Take Apple [AAPL] as an example. It has had several stock splits, and, if you look back at its stock price in 1990, you’ll see that it was priced at less than $0.50. You might find it hard to imagine AAPL trading so cheaply; in reality, it wasn’t. But, due to several stock splits that continuously lowered the price, historical data has been adjusted. This allows us to reliably judge AAPL’s performance over time!
Summary
A stock split is a decision made by a company to manipulate its stock price by shrinking or increasing the number of shares. Forward stock splits provide new shares and lower the stock price. Reverse stock splits reduce the number of shares and increase the stock price. As an investor, your position remains the same, but you can keep an eye on stock splits to monitor the health of a business.
