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What is a stock split?
Stock splits are a way a company’s board of directors can increase the number of shares outstanding while lowering the share price. It's a tactic for making a stock more attainable to smaller investors, particularly when its price has ratcheted sky-high over time.
Two recent examples: In the first quarter of 2022, both Amazon and Google parent company Alphabet announced 20-for-1 stock splits, meaning current investors receive 20 shares of the stock for every one share they own.
While neither the company’s value nor that of your investment changes in a split, it’s important to understand how stock splits can impact your portfolio. Here’s what you need to know.
Stock splits are accompanied by somewhat confusing arithmetic, such as “2-for-1” or “3-for-2.” As with many things in life, pizza can help.
Imagine a company’s value represented by an entire pizza. When its stock began trading, that pizza was sliced into a finite number of pieces, or shares, that were offered to investors. For simplicity’s sake, let's say the pizza was divided into eight slices and you owned one share.
If a company announces a 2-for-1 split, the number of shares doubles, so the original pie will be divvied up into 16 slices. Whereas you owned one-eighth of the company before, as a result of the split you’ll now own two-sixteenths. Same amount of pizza, just a different number of slices.
That same principle is applied no matter what the split ratio is. (Have an appetite to learn more? Check out some other stock market basics.)
There is also such a thing as a “reverse” stock split — as the name suggests, this kind of split goes the opposite way: The number of shares is reduced, but the price per share increases. This is often done to meet the minimum stock price required for a company to be listed on an exchange.
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What happens when a stock splits
A stock split doesn't make investors rich. In fact, the company’s market capitalization, equal to shares outstanding multiplied by the price per share, isn’t affected by a stock split. If the number of shares increases, the share price will decrease by a proportional amount.
If a stock traded at $100 previously, it will trade at $50 after a 2-for-1 split. Yes, you own more shares, but they’re each worth less. It’s basically a draw, and the value of your investment won’t change.
However, investors generally react positively to stock splits, partly because these announcements signal that a company’s board wants to attract investors by making the price more affordable and increasing the number of shares available. As a result, your portfolio could see a handsome benefit if the stock continues to appreciate. Studies show that stocks that have split have gone on to outpace the broader market in the year following the split and subsequent few years.
How to take advantage of a stock split
You need to be a shareholder by a certain date, specified by the company, to qualify for a split.
If you're not yet an investor in a company, and a stock split has made its share price more affordable, you'll want to research the stock to ensure it's a good investment for your portfolio before you buy. If it is, you can follow our guide to learn how to buy stocks.
Disclosure: The author held no positions in the aforementioned investments at the original time of publication.