Understanding Stock Splits: Impacts on Forward vs Reverse Stock Splits

For those investing in the stock market, you should know what is a stock split, their types and how it works for your investments. Often, the misunderstanding of the concept from less experienced investors causes confusion when they start panic selling thinking their investment is losing value. Knowledge is power, so on this post we will review stock splits, types, what happens after a stock split and some known cases to have some background.

Firstly, with a definition, a stock split is a corporate action taken by a company to increase the number of its outstanding shares by dividing its existing shares into multiple new ones. While this process does not alter the company’s market capitalisation or the value of a shareholder’s investment, it has significant implications for the stock’s price, accessibility, and market dynamics. As we said for investors, understanding stock splits and their ramifications is crucial to making informed decisions in the stock market.

What Happens During a Stock Split?

When a stock split occurs, a company increases the number of its outstanding shares, and the price of each share is adjusted accordingly. The overall value of the shares remains the same (so you are not losing / gaining money), as the company’s market capitalisation—calculated as the stock price multiplied by the total number of shares—is unaffected by the split.

For example, take an example a company with 1,000,000 shares that announces a 2-for-1 stock split, that means that each existing share is divided into two shares, so after the stock split there will be 2,000,000 shares. If the stock was trading at £100 before the split, the price of each new share would be halved to £50, while the total number of shares held by an investor would double. So if at the start you had 10 shares at £100 each, that is a total of £1,000 (10 shares x £100 each). After the stock split you would have 20 shares at half price, making a total of £1,000 (20 shares x £50).

Types of Stock Splits

Stock split as its name says, is splitting the stock, however this term is also used for a reverse stock split. There are two main types of stock splits: forward stock splits and reverse stock splits. Each serves a different purpose and has distinct implications for the market and investors, so lets dig deeper on what is happening on each case and how is the market normally reacting to them.

1. Forward Stock Splits

This is the one that we mentioned before, a forward stock split increases the number of shares outstanding by dividing each existing share into multiple shares. This type of split is typically implemented when a company’s share price has risen significantly, making it less affordable for retail investors. For example, Amazon was recently at over $3,000 a share, and although split for investor has not real change on their investment, is more a psychological effect on those that see $3,000 as an impossible target, while $50 dollars would be accessible for everyone.

Common Ratios for Forward Stock Splits:

Stock splits is not always a division in two, and there are also most rations, however the most commons are:

• 2-for-1: Each share is split into two.
• 3-for-1: Each share is split into three.
• 5-for-1 or Higher: Less common but used by companies with very high stock prices.

Impact on Investors: While the price per share decreases, the total value of the investment remains unchanged. The lower price often makes the stock more accessible to a broader range of investors, potentially increasing demand and liquidity. Although really, with platforms that give you access to fractional shares this doesn’t make a difference.

2. Reverse Stock Splits

A reverse stock split decreases the number of shares outstanding by consolidating multiple shares into one. Companies usually undertake reverse splits when their stock price has fallen to very low levels, which may put them at risk of delisting from stock exchanges. These normally have minimum stock prices to be included. Having a very low price could lead to confusion for investors that may think the stock is a ‘penny stock’.

Common Ratios for Reverse Stock Splits:

• 1-for-2: Two shares are combined into one.
• 1-for-10: Ten shares are combined into one.
• 1-for-50 or Higher: Often used by struggling companies.

Impact on Investors: The price per share increases proportionally, but the total value of the investment remains the same. While reverse splits may restore a company’s compliance with listing requirements, they can sometimes signal financial distress, which might deter potential investors.

Why Do Companies Implement Stock Splits?

Companies choose to split their stock for various strategic reasons, although we have briefly discussed, these are some of the most common motivations:

1. Enhancing Liquidity: Lowering the stock price through a forward split makes shares more affordable to a wider range of investors, increasing trading activity and liquidity.
2. Improving Market Perception: A stock split can signal confidence in the company’s future growth prospects, encouraging investor interest.
3. Meeting Exchange Requirements: Reverse stock splits are sometimes necessary to meet the minimum price requirements of stock exchanges, preventing delisting.
4. Aligning with Peer Companies: Companies may split their stock to maintain parity with competitors in terms of stock price and accessibility. This is the less likely reason.

What Happens Statistically After a Stock Split?

Forward Stock Splits

Every case is a different world however some research suggests that forward stock splits are often followed by positive market reactions. Key observations include:

• Increased Liquidity: The reduced stock price attracts more retail investors, leading to higher trading volumes as more people see the stock on their reach.
• Short-Term Price Gains: Stocks often experience a temporary uptick in price post-split due to increased demand and market optimism.
• Long-Term Growth Correlation: While splits themselves do not increase a company’s intrinsic value, they are often implemented by companies with strong growth trajectories, leading to long-term gains.

Reverse Stock Splits

In contrast, on the reverse stock splits is not that clear what happens after and there are more mixed reactions from the market:

• Initial Price Volatility: While the stock price per share rises, the reduced number of shares can lead to increased price volatility.
• Negative Perception: Investors may view reverse splits as a sign of underlying financial challenges, potentially leading to sell-offs.
• Improved Compliance: Companies regain eligibility for trading on major exchanges, which can stabilise the stock over time.

Tax Implications of Stock Splits

Stock splits generally do not trigger taxable events for investors. Since the total value of an investment remains unchanged, there is no realised gain or loss to report, you will have exactly the same. However, if the stock is booming after the split and you don’t have your holdings in a tax efficient way that could generate tax implications. We have a little UK tax guide for stock and crypto gains. What you will need is to update your records as you will have to adjust the cost basis of your holdings to reflect the new share quantity and price. We always advise to have proper record-keeping that ensures accurate tax calculations when the shares are eventually sold.

How Should Investors Respond to Stock Splits?

1. Evaluate the Company’s Fundamentals: A stock split does not alter a company’s intrinsic value. Investors should assess the company’s financial health, growth prospects, and market position before making decisions.
2. Consider Market Sentiment: Forward splits often generate positive sentiment, while reverse splits may indicate caution. However, these are not definitive indicators of future performance.
3. Diversify Your Portfolio: Whether a stock is splitting or consolidating, like many people say, maintaining a diversified portfolio reduces the risk associated with individual investments.

Real-World Examples of Stock Splits

Forward Stock Split Example: Apple Inc.

For those new to investing, Apple is going of those stocks that have done few stock splits. Apple conducted a 4-for-1 stock split in August 2020, reducing its share price from around $500 to approximately $125. This move increased accessibility for retail investors and was followed by a rise in trading volumes and continued strong performance.

Reverse Stock Split Example: Citigroup Inc.

In the opposite way, a large company as the bank Citigroup was conducting a reverse stock split in 2011 when executed a 1-for-10 reverse stock split to boost its stock price above $40 after it had been trading below $5 during the financial crisis. The move helped the company regain compliance with listing standards but was met with scepticism by some investors at that time.

Conclusion

As you have discovered today on this post, stock splits, whether forward or reverse, are significant corporate actions that impact stock prices, market perception, and investor behaviour. While they do not change a company’s underlying value, they can influence market dynamics and accessibility. For us as investors, understanding the mechanics and implications of stock splits is essential for making strategic investment decisions. We as investors should be focusing on the company’s fundamentals and market trends, so we can navigate stock splits with confidence and potentially capitalise on the opportunities they present.