If you own the stock of a company that executes a stock split, the details of your position change, but the total value of your position does not. Here are the key things to know about stock splits.
What is a stock split?
A stock split divides each share into several shares. The most common type of a stock split is a forward stock split. For example, a common stock split ratio is a forward 2-1 split (i.e., 2 for 1), where a stockholder would receive 2 shares for every 1 share owned. This results in an increase in the total number of shares outstanding for the company, though no change in a shareholder's proportional ownership. Normally, a stock split will reduce the price per share of each share in proportion to the increase in shares.
Using this example, a 2-1 split for a stock trading at $200 would halve the price to $100 and double the number of total shares outstanding.
Why might a company decide to do a stock split?
Management of a company might decide to do a forward stock split if they believe the price is relatively "high" or that it is trading outside of an "optimal" range. This decision is made by management based on their subjective views of the historical trading range of the stock and other factors.
A company may initiate a reverse stock split if they believe the stock price is relatively "low" or to avoid being delisted (some exchanges have minimum share price requirements). In a 1-2 reverse stock split for a stock trading at $2, for example, you would receive 1 share for every 2 shares you owned after the split and the stock price would double to $4. Again, the total value of your investment would not change due to the stock split.
How does a stock split impact your holdings/portfolio?
The critical thing to understand about a stock split (including a reverse stock split) is that the proportional ownership of your position is unaffected by the split, and it is the market that will determine the impact on the total value of the position. While the number of shares owned changes after a stock split, the split itself does not change your investment value.
For example, suppose you own 100 shares of a company trading at $200 per share, for a total value of $20,000. All else equal, if the stock split 2-1, you would then own 200 shares of the company at $100 per share after the split for the same total value of $20,000.
Some investors believe that a forward stock split is a signal by management to investors that the company believes the stock value is attractive. Moreover, the stock may become more accessible to additional investors at a relatively lower price.
It can be the case that a company's stock price may rise immediately after a stock split announcement (due to this management-signaling effect). There is some evidence that companies who split their stock outperform the broad market over the near term.1
Of course, this does not mean a stock will rise after a stock split announcement or when it goes into effect. Remember, a stock split in and of itself does not impact your holdings' value. Without strong earnings, dividend growth, or some other positive news for the company following the stock split, any gains made by the stock following the stock split announcement would likely fall back to (or below) the presplit announcement.
A company will typically announce a stock split several weeks before the split actually occurs. Consequently, there is a window between the announcement and the stock split. You would not want to base your decision to buy (or sell) a stock based solely on a stock split. A stock split does not change the value of a stock because it does not change the fundamentals or growth prospects of the underlying company. If you have determined that you want to buy the stock of a company that has announced a split, your decision when to buy can be based on your research, objectives, risk constraints, and any other considerations relative to your strategy.
Other management decisions regarding its stock—such as changes to a dividend payment or a new stock offering—have implications for the company's fundamentals, and thus, your investment value. But a stock split does not.