A stock split occurs when a firm decides to expand the total number of its shares to enhance the stock's liquidity. Because a stock split does not fundamentally alter the value of the firm, the total dollar worth of all shares that are now outstanding does not rise even though the number of shares that are outstanding grows by a particular multiple. So, what are reverse stock splits?

Two-for-one and three-for-one are most typical split ratios. This implies that following the split, each shareholder will get two or three shares, depending on how many shares they had before the split.

How a Stock Split Works

A stock split is a corporate action in which a company issues additional shares of stock to its existing shareholders, increasing the total number of shares outstanding by a specified percentage based on the shares owned prior to the split. This effectively increases the number of shares held by each shareholder. The purpose of a stock split is typically to adjust the trading price of the company's stock to a more desirable range for investors and to enhance the liquidity of the stock.

For instance, investors generally prefer to purchase multiple shares of a stock priced at a lower price per share rather than a single share at a higher price. Therefore, when a company's stock price rises significantly, it may announce a stock split to reduce the price per share. Importantly, a stock split does not change the overall value of the company, as the total value of the shares outstanding remains the same after the split as it was before the split, just distributed among a larger number of shares.

A corporation's board of directors can split on any ratio for splitting the firm's stock. A stock split may, for instance, be 2-for-1, 3-for-1, 5-for-1, 10-for-1, 100-for-1, or any other number in between. In the case of a 3-for-1 stock split, it indicates that investors will now have three shares for every single one that they already own. To put it another way, the market's total number of outstanding shares will increase by a factor of three.

On the other side, after the stock split, the price of each share will be lower since it will be calculated by dividing the previous share price by three. This is because a stock split does not affect the firm's value as determined by market capitalization.

Advantages of a Stock Split

Why do firms put themselves through the headache and additional cost of splitting their stock? First, a stock split is often decided upon by a firm when the stock price is relatively high. When the stock price is high, it is difficult and costly for investors to purchase a conventional board lot consisting of 100 shares.

Second, if there are more shares in circulation, the stock may have larger liquidity, which makes trading easier and may cause the difference between the bid and the asking price to become less. Making a stock more liquid makes it simpler for buyers and sellers to engage in stock transactions. Since of this, businesses may be able to repurchase their shares at a lesser cost because the influence that their orders will have on more liquid security will be reduced.

Although a stock split should, in principle, have no impact on the price of the company's stock, it often leads to fresh investor interest, which may positively impact the stock price. Investors can take heart from stock splits announced by blue-chip businesses, even if the impact of these splits may become less pronounced over time. For this reason, a stock split often signals executive-level confidence in a firm's outlook. Some may interpret a stock split as a corporation's desire to have a larger future runway for expansion; however, this is not always the case.

Disadvantages of a Stock Split

A stock split may benefit a corporation in many ways, but not all of them. A stock split is a costly operation involving legal counsel monitoring and must be carried out in compliance with industry regulations. If the corporation wants to avoid any change in its overall market capitalization value, it will have to pay a significant stock to split its stocks.

Although a stock split does not have any value at all, since it does not affect the basic position of a firm, it does not result in the creation of any new value. A stock split has been compared to the process of slicing a piece of cake by some. It makes no difference how many portions of the dessert are served if each one has an unpleasant flavor if they are all sliced into the same size.