Series 7: 1.2.2.3.1. Stock Splits

1.2.2.3.1. Stock Splits

If a company believes that its share price has become too expensive for individual investors, the company may execute a stock split. Most companies want a broad shareholder base, so it’s in their best interest to keep their stock price within reach of most investors. The most common stock split is 2-for-1, but 3-for-1 and 3-for-2 are also common, and any ratio is permitted. Like a stock dividend, when a stock split occurs, the value of each shareholder’s interest remains the same, as does market capitalization of the company. What changes is the number of shares outstanding and the price of each share. In the case of a 2-for-1 stock split, the number of shares doubles and the share price halves. To get this, you multiply the number of shares by the split ratio of two and you divide the share price by the same ratio. In the case of a 3-for-2 split, the number of shares increases by 50% and the share price drops to two-thirds of what it was pre-split. To figure this out, multiply the number of shares by the split ratio (3/2, or 1.5) and divide the share price by the same split ratio.

Sometimes, a company will decide that its share price is too low. The company may worry that a low share price hurts the company’s image or the share price may be too low to meet continued listing requirements on an exchange. When this occurs, the company may carry out a reverse stock split. It means current investors exchange their current shares for a lesser number of shares, though the value of the investor’s interest remains the same. In a 1-for-2 split, for example, the number of shares an investor owns will be reduced by half, but each share will be worth twice its former value—so the investor’s total investment value will remain the same after the split. Likewise, there is no change to the company’s total market capitalization after a reverse stock split.

Sample Question

Hot Box Lunches Corporation carries out a 1-for-5 split. S