• Shahn Khan

Stock forward splits and reverse splits explained

A stock split is a decision that a publicly-traded company makes to adjust the total number of shares that the company has issued. The outstanding shares of stock are adjusted by dividing or multiplying each share by a predetermined amount. When a company lowers the price of its stock by splitting each existing share into more than one share and the new price of the shares correlates to the new number of shares, the value of the shareholders' stock doesn't change and neither does the company's market capitalization.

The majority of stock splits are 2-for-1 meaning that for every one share of stock owned, one additional share will be received with the result being that the shareholder will own two shares for every one share currently held.

Reasons for a Stock Split

If there’s no change in its market capitalization, why would a company issue a stock split? There are several reasons. The most common is that the company believes its shares are overpriced. This is not the same as saying they believe the stock is overvalued.

If a stock’s price rises into the hundreds of dollars per share, it tends to reduce the stock's trading volume. Increasing the number of outstanding shares at a lower per-share price adds liquidity. This increased liquidity tends to narrow the spread between the bid and ask prices, enabling investors to get better prices when they trade.

By lowering the share price and increasing available shares, the company can make it more attractive and accessible to improve investor relations. A company may also choose to issue a reverse split to soak up outstanding shares and increase the price per share. Both methods can be used to keep a share price within a certain range to encourage specific investor participation at various stages of the business life cycle. Stock splits also tend not to drastically impact each shareholder of record.

Another reason that a company may choose to issue a stock split is to increase the liquidity of its stock. Liquidity is a measure of how quickly shares can be bought or sold in the market without causing the stock price to increase significantly.

Stock splits could increase volatility in the market because of the new share price. More investors may decide to purchase the stock now that it is more affordable, and that could increase the volatility of the stock.

Many inexperienced investors mistakenly believe stock splits are a good thing is because they tend to mistake correlation and causation. When a company is doing really well, a stock split is almost always inevitable as book value and dividends grow. If a person sees or hears about this pattern frequently enough, the two may become associated.

However, there is a recognized halo effect that can happen to a stock immediately after a stock split. In this case, a company’s stock may rise after a stock split because investors perceive that the company is more attractive. Some of the risks associated with stock markets and exchanges have been mitigated by organizations, such as the Securities and Exchange Commission.

Reverse stock split

the net effect is exactly the opposite of a stock split. The number of outstanding shares decreases while the price per share increases by the same factor. Reverse stock splits are typically done to discourage investor speculation and to prevent a company’s stock from being delisted on a major stock exchange. To avoid being surprised by any changes to your portfolio of stocks you may want to track or receive alerts when stock splits are scheduled.

While forward splits and reverse splits both have no impact on the total amount an investor has invested in the stock or fund, the former is considered a positive and growth move by the company, while the latter is to help prevent the stock from being delisted on the exchange.

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