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Stock splits are a corporate action in which a company divides its existing shares into multiple new shares.
The primary goal of a stock split is to make the stock more affordable to a broader range of investors and potentially increase liquidity.
When a stock split is approved and announced by the board of directors of a public company, they decide the ratio of the split, which can be anything from 2:1 to 5:1 and beyond.
The company announces the split and specifies the effective date when the split will take place. This is when the new shares will be distributed to shareholders.
On the effective date, the stock price is adjusted based on the split ratio. For a 2-for-1 split, each old share is divided into two new shares, and the stock's price is halved.
If a stock was trading at $100 per share before the split, after a 2-for-1 split, it would trade at $50 per share.
Effects On Existing Shareholders
It must be noted that stock splits have little to no noticeable effect on existing shareholders, which is an integral part of any stock split. When a stock is split by a certain ratio, the existing shareholders also increase their shares by the same ratio, without incurring additional costs.
This is to ensure the satisfaction of existing shareholders and avoid diluting their investments in the company.
Reverse Stock Splits
On the other hand, companies may also go through a reverse stock split, where they decrease the number of available shares on the market by a factor decided by the board of directors.
For example, in a 1:5 reverse split, every five existing shares are combined into one new share.
The primary goal is to increase the stock's price per share. This is often done to meet minimum price requirements for stock exchange listings or to boost investor confidence.
While a reverse split can raise the stock price, it typically reflects financial difficulties or low market confidence, and it doesn't change the company's market value or fundamentals.
Stock Split Example - Tesla Inc (TSLA)
A notable example of a stock split was Tesla in 2022, when the stock was trading between the $800-$1,000 range, which was deemed too expensive for traders. Therefore, the company initiated a 3:1 stock split, increasing the shares of existing shareholders by a factor of 3 and decreasing the share price by the same ratio.
While traders can buy and sell Tesla shares easily using fractional shares, this is not universally available. Therefore, Tesla managed to make its shares more accessible to a much broader group of investors by going through with the stock split.
