There are many ways you can slice a pie and reasons why you might want to serve larger or smaller pieces, but if you go too big, the size of a piece can become overwhelming. Sometimes, the same could be said of stocks.
When a stock price gets high, sometimes a public company will want to lower that price and can do that with a stock split.
A stock split is a decision by a company’s board to increase the number of outstanding shares in the company by issuing new shares to existing shareholders in a set proportion. Stock splits come in multiple forms, but the most common are 2-for-1, 3-for-2 or 3-for-1 splits.
For example, let’s say you owned 10 shares of a stock trading at $100. In a 2-for-1 split, the company would give you two shares with a market-adjusted worth of $50 for every one share you own, leaving you with 20 shares. Or, in a 3-for-2 split, the company would give you three shares with a market-adjusted worth of about $66.67 in exchange for two existing $100 shares, leaving you with 15 shares.
While you now have more shares than you started with, the total value of those shares is the same as it was before the split: $1,000. And while the company’s shares outstanding increase with the split, its market capitalization—the total value of the company derived from multiplying the number of shares by the stock price—remains the same, too.
One reason companies split their shares is that a psychological barrier might occur with trading high-priced shares. A very high stock price can intimidate investors who fear there is little room for growth, or what is known as price appreciation. Meanwhile, a company with a very low-stock price might engage in the opposite behavior: a reverse stock split, to increase its per-share price.
A reverse stock split tends to occur with small companies that believe their stock price is too low to attract investors. Companies also might do reverse splits to maintain their listing on a stock market that has a minimum per-share price or to appeal to certain institutional investors who might not buy stock priced below a certain amount.
More often than not, a reverse split involves a company that trades in the over-the-counter markets (OTC). Reverse stock splits are less common among seasoned companies that trade on one of the major U.S. stock exchanges.
If a reverse split is announced and actually occurs, proceed with caution. Reverse splits tend to go hand in hand with low-priced, high-risk stocks. This is especially true with reverse splits that result in a post-split share price that is many times the price of the stock's current price.
Here's how a reverse split works: Say a company announces a 200:1 reverse split. Once approved, investors will receive one share for every 200 shares they own. So, if you owned 5,000 shares of stock at a price of 10 cents per share worth a total of $500 before the reverse split, you would own 25 shares at a price of $20 each after the reverse split, maintaining that total value of $500. The amount of money you have invested doesn't change, just the number of shares you own.
The Role of Regulators
As the Securities and Exchange Commission (SEC) explains, "state corporate law and a company's articles of incorporation and by-laws generally govern the company's ability to declare a reverse stock split and whether shareholder approval is required."
If a company is required to file reports with the SEC, it may notify its shareholders of a reverse stock split in a number of ways, including on Forms 8-K, 10-Q or 10-K. Use the SEC's EDGAR search tools to view these reports.
FINRA does not approve reverse splits, but it does process reverse stock splits as part of its functions related to company corporate actions in the OTC market. OTC companies must submit notice to FINRA 10 days prior to the record/effective date of the corporate action. Once a corporate action submission is successfully processed (which may take longer than 10 days), it will be posted to the OTC Daily List, where investors can learn about reverse stock splits and other company corporate actions, such as a merger or acquisition, payment of dividends or a company dissolution or liquidation.
Remember that a stock split—or a reverse stock split—does nothing to change the value of a company. How a stock performs in the long run will depend on multiple factors, not on how its shares are split.