What Does the Financial Term Stock Split Mean?
An announced stock split is usually seen as a positive development by investors in the splitting stock. A corporation's board of directors can elect to declare a stock split to reduce the share price of the company's stock. Even though the stock price is reduced, the value of an investor's holdings is not reduced by a stock split.
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Function
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When a company declares a stock split, shareholders have their shares replaced by a new amount of shares based on the split ratio. For example, if a company declares a two-for-one split, shareholders will receive two new shares for each share they currently hold. After the split the total number of company shares outstanding will change by the split ratio. If a company has 10 million shares outstanding and declares a 2-1 split, there will be 20 million shares outstanding after the split.
Effects
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A stock split does not change the total market value of the company. To compensate for the larger number of shares, the stock price is reduced in proportion to the split ratio. If the share price was $100 before a 2-1 split, the shares will be worth $50 each after the split. An investor will still own shares with the same market value. If an investor holds 100 shares worth $100 before the split, the investor will have 200 shares worth $50 each after the split. The investor's value stays at $10,000.
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Types
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A corporation can declare a stock split in any ratio. Common split ratios are 2-1, 3-1 and 3-2. The share price would be adjusted by the amount of the ratio. If a stock is at $60 before a split, the share price would be $20 after a 3-1 split and $40 after a 3-2 split. Investors will always have an increase in shares to maintain their investment value at the same level as before the split.
Potential
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Corporations declare stock splits to keep the share price where the board of directors believes the shares have the most liquidity and market interest. Investors may be more interested in a $50 stock than a $100 stock, which looks expensive. A declared split is usually perceived by investors as an indication that the corporation's board of directors believes the share value will continue to go higher.
Reverse Split
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A corporation can also declare a reverse split to decrease the number of shares and increase the share price. For example, if a 1-10 reverse split is declared for a $1.00 stock, investors will end up with one-tenth as many $10 shares. Reverse splits are often seen as a sign of desperation as a company tries to avoid the de-listing from the stock exchange of its low-priced stock.
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