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A stock split is a type of corporate action that replaces shares in a public company with more shares in the same company at a lower price. Although this leaves the market capitalization of the company the same, an increase in the number of shares leads to greater liquidity, and therefore a greater volume of trades. This often leads to a higher stock price in the short term. The lower price per share also makes the company more accessible to some smaller investors. However, the practice doesn't suit all investors as it tends to make the stock change hands more frequently, and therefore hurts the long term investor. The influential investor Warren Buffett does not approve of the practice.
For example, a company with 100,000,000 shares outstanding and a stock price of $50 per share has a market capitalization of $5,000,000,000. If the company initiated a 2-for-1 stock split, every investor in the company would be given 2 shares at $25 for every 1 share at $50. Then the company would have 200,000,000 shares outstanding with a price of $25 per share, so the market capitalization remains $5,000,000,000. 2-for-1 splits are the most common, but others include 3-1, 3-2, 4-3, 5-2, and 5-4.
The reverse stock split, or consolidation, is not as common. It can be used by a company for several purposes:
- To drive up the raw price of the shares, while leaving the valuation the same. This is mostly used when a company's share price drops into the pennies, which makes it disappear from many financial companies' radar.
- As a last-ditch effort by company management to avoid delistment from stock exchanges and as a means of making a struggling company appear more valuable without actually changing anything. Reverse splits are generally frowned upon by investors as they send out a bad signal.
- As a means to push out minority shareholders. This is because the reverse split will most likely leave them holding less than the required minimal stocks.
- As a means of going private. The Securities and Exchange Commission requires a company to have at least 300 shareholders for it to be considered public. A reverse stock split that results in less than 300 shareholders can therefore remove a company from SEC regulations.
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