2.1.1.3.1 Stock Splits
If a company believes that the price of its stock has risen too high for the 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 a 2-for-1 split, but 3-for-1 and 3-for-2 are also common, and any ratio is permitted.
When a stock split occurs, the value of each shareholder’s interest remains the same, as does the 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 is cut in half. To calculate this, multiply the number of shares by the split ratio of two and 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 before the split. To calculate this, 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 its 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. In this case, current investors receive fewer shares for their current shares, while the value of their overall investment will remain 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.
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