Financial Definitions: What Are Stock Splits And Reverse Stock Splits?

A quick view of stock splits, reverse stock splits and what they mean to the investor.

You've been holding a stock for years, enjoying a gradual, but steady increase in market value, ensuring a piece of what you hope will be a comfortable, prosperous retirement. One day you receive a notice in the mail from the company you own stock in and they are announcing to their shareholders their intent to perform a stock split. Is this good or bad? What will this mean to you as a shareholder?

It is neither time to panic, nor necessarily celebrate. Say you own one hundred shares, or one round lot, of XYZ stock at $50 per share. The total market value of your stock is $5000. The company has announced their intentions of initiating a two-for-one stock split. You will then own two hundred shares of XYZ stock at $25 per share for a grand total of $5000 in value. You haven't made a dollar, nor have you lost a dollar. The value of your holdings will remain the same.

A publicly traded company might choose to split their stock for a number of reasons. Often, in the case mentioned above, a stock has been steadily rising over the course of months, but usually years. As it has risen, the attractiveness of the stock in the market place may begin to decline. For example, the stock had traded two years ago at $50 per share. Today, it trades at $80 dollars a share. Obviously, the increase in value is good, but potential new buyers of the stock may be holding off on the purchase because the price is too high when compared to other variables.

One option is to split the stock to encourage more activity on the buy side. Investors may not find the stock an attractive purchase at $50 per share, but it may fall within their financial goals and guidelines at $25 per share. Again, it will not change the current investor's holdings dollar value. Splits can be two-for-one, or any combination the company deems necessary to increase activity in the market.

Inversely, there is the reverse stock split. When a company's stock trades at a low dollar value, investor perception may be that it is too "Ëścheap', meaning it must be trading at a low dollar value for a reason. Some investors and investment firms shy away from stocks with a value below $3 per share due to the possibility of it being either a volatile stock, or an unstable company. To address this perception, companies might initiate a reverse stock split. An example would be XYZ stock trades on the New York Stock Exchange at $2.50 per share, and you currently hold one round lot, or one hundred shares for a total dollar value of $250. To entice more conservative investors, the company decides to conduct a two-to-one reverse split of the stock The result will be that you now own fifty shares of XYZ stock at $5.00 per share, with a total market value of the same $250 you started with. The difference is that the stock falls above the $3.00 per share threshold and may encourage participation from the conservative element of investors.

So when that letter comes in the mail, don't pop open the bubbly and don't put a for sale sign in front of the house. It is likely that the company is merely taking measures to encourage the stock to either begin, or continue to rise. While there are no guarantees in the stock market, it is an indication that the company's management is addressing price issues and is interested in stronger stock values - a win-win situation for you, the stockholder.

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