Investopedia defines a stock split as “A corporate action in which a company’s existing shares are divided into multiple shares….” While this sounds like a rather simplistic definition, it is as simple as that. To understand what happens when a company splits their stock, there must be a basic understanding of how stock is issued by a company, how the price impacts stock splits and whether the split is a regular split or a reverse split.
When companies issue stock
When a company first decides to go public (and in some cases private companies issue stock internally) the board of director’s makes a decision as to how much stock will be issued by the company. This process will sometimes involve different classes of stock such as common stock, preferred stock, convertible stock and treasury stock. Stocks shares that are held by shareholders and company insiders are further identified as shares that are outstanding. Treasury stock may be shares that are issued and later purchased back from shareholder’s or may not have been issued. These stocks are not traded actively, instead they are held for future financial needs.
Typical stock split
When a company determines that their stock prices have become too high for average shareholder’s to afford, they may consider a stock split. A good example of this type of stock is “Berkshire Hathaway Class A” (NYSE: BRK-A) stock which currently trades for more than $100,000 a share. If Berkshire were to decide to do a stock split, they could do a three for one split and the shares would then be worth more than $30,000 per share. However, the overall position for all existing shareholders would not change.
The reason that the shareholder’s position would not change is because in the example above, people who own one share of BRK-A would be entitled to three shares. Their overall “cash” position would remain the same, but the new shares would be worth less per share. There are times when a company has split their shares that they find that there is more demand which drives the price up again, because the shares are more affordable.
Reverse stock split
Reverse stock splits work in a different manner than a standard stock split, but the end results are nearly the same. Reverse stock splits are most commonly used by companies that have seen their stock shares decline in value and may be risking de-listing on the stock market. Both the NASDAQ (National Association of Securities Dealers Automated Quotations) and NYSE (New York Stock Exchange) impose minimum stock prices for a company to stay listed.
In March of 2011, CNN Money reported on a reverse stock split by Citigroup (NYSE:C). This action was taken because their shares had dropped to $4.50 per share. Citigroup did a ten-to-one reverse split. The end result was anticipated to increase the single share value to $45.00 per share. In this case, shareholder’s who held 100 shares of Citigroup ended up with only 10 shares. The difference is that the 100 shares were worth $4.50 each while the 10 were worth $45.00 (as of June 10, 2011 the shares are worth just over $37 per share). This type of action is typically undertaken when a company wishes to maintain their listing status.
For those who hold shares in a company a split does not necessarily change the value of their shares, it merely changes the number of shares that they have in their portfolio. All stocks carry some risk and the risk of a regular, or reverse stock split is one of those risks. Companies must approve these types of transactions and in some cases, the shareholders may be asked to vote on this type of action. Unfortunately, if investors are not fully informed of the end result of a reverse stock split, the company may face de-listing from the stock exchange and become nearly worthless.