What is a Stock Split?

Q. What is a stock split?

A: A stock split allows a company to create and issue new shares to current investors. For example, in a 2-for-1 stock split, shareholders would get two new shares in exchange for each share held. While you end up holding more shares, a stock split reduces the price of each share so the overall value of your holdings doesn't change. Here's what we mean:

Think of one share in a company like a chocolate bar that costs $1. A stock split means the company could split the bar into smaller pieces — say, two at 50 cents a piece (a 2-for-1 split), four at 25 cents (4-for-1) or 10 at 10 cents (10-for-1). The value of the whole chocolate bar stays the same, but now there are smaller chunks available at a lower price per piece. In a stock split, the price of a single share decreases but the number of outstanding shares available on the market increases — which means the market capitalization of the company stays the same.

Before diving further into the details, here are a few terms to know.

Outstanding shares are all of a company's issued shares. The total number of shares is important for calculating various data points that measure the health of a company — earnings per share, market capitalization and more.

Market capitalization, or "market cap," is the market value of a company's outstanding shares — the total number of shares multiplied by the price of one share at any given time.

Liquidity refers to the ease with which an asset can be bought and sold. Is there a market out there for what you're buying or selling? How quickly and easily can you find a buyer or seller?

Why split the stock?

Generally speaking, a company might consider a stock split if its price has increased more than it feels is beneficial. For example, if a stock price gets too high, it may deter smaller investors that the company wants to attract. A stock split can also have a positive effect on market sentiment toward a stock by bringing attention to the company and the fact that its stock price has been rising. Liquidity is another consideration. When there are more outstanding shares on the market, priced more cheaply, liquidity tends to increase.

Stock splits in reverse

Splits can also happen in the other direction. These are known as reverse splits, or share consolidations. If a company feels its stock price is too low, or shares have decreased to a detrimental level (for example, below a stock exchange's minimum share-price requirement), it may opt for a reverse split. This would essentially be putting the chocolate bar back together. A 1-for-4 consolidation, in which a shareholder would receive one new share for every four shares held, would be like the company taking back four pieces of your chocolate bar at 25 cents a pop and returning to you one full bar worth $1. Again, the value of the chocolate bar remains the same, but now only larger pieces are available at a higher price. In a reverse split, the price of a single share increases, but the number of outstanding shares available on the market decreases. But again, the market capitalization of the company stays the same.

What does it mean for your portfolio?

Well, not much overall. If you own shares in a company that splits its stock, you'll own more shares (or fewer in the case of a reverse split), but the value of the shares you own remains the same. While there are examples of stock prices that rise after a split — based on an increase in the number of investors interested in and able to purchase shares at the new, lower price — this is by no means the general rule.

Should you have a dividend¹ reinvestment plan (DRIP²) set up, a stock split would mean your dividend payout would get you more shares of your investment than before the split. For example, if a $100 stock were to split on a 2-for-1 basis, a dividend payout of $100 could get you two shares at $50 compared with just one share at $100 pre-split.