What is a stock split and how it works

Stocks go up; they go down; they go sideways, and sometimes they do something you might not expect they split. There are two types of stock splits: conventional and reverse. A conventional stock split occurs when a company divides its existing shares into more shares.

The number of shares increases, but the price of each share decreases, so the total value of the company’s shares remains the same. Think of it like cutting a cake: cutting more pieces doesn’t mean you have less cake you just have smaller pieces. For example, in June 2014, Apple split seven for one, meaning each share became seven. Apple went from having roughly 861 million outstanding shares at about $645 per share to about 6 billion shares at about $92 per share. Despite there being more shares, the total value of Apple’s market cap remained the same at roughly $555 billion.

A company typically splits its stock when the price of its shares is high. High prices can make it difficult for investors to buy the standard trading unit of 100 shares. Ideally, a lower price allows more investors to buy the stock, potentially increasing its liquidity. So what happens if you own a stock that splits? Just like a split doesn’t change the total value of the company’s shares, it doesn’t change the total value of your shares.

Let’s return to the Apple example. If you had owned one share at $645 before the split, you would’ve owned seven shares at around $92 after the split give or take a few cents when rounding the numbers. The total value of the shares would still be $645. One common belief that investors have regarding stock splits is that a stock’s price will go up after a split.

Although some studies show that stocks that split outperform in the years following, a stock split is not a guarantee that a stock’s value will go up. Investors should do additional research and look at the stock’s overall financial health. The opposite of a conventional stock split is a reverse stock split.

During a reverse stock split, a company decreases its number of shares in order to increase the price of each share. Companies often choose to enact a reverse stock split when shares fall below the minimum price of the exchange listing requirements. Stocks that fall below the exchange minimum are in danger of being delisted, which means they can’t be traded on the exchange.

For instance, in July 2009, the center of the financial crisis, the American International Group, or AIG, reverse split its shares one for 20 to stabilize its stock price. Investors who owned 20 shares valued at about $1 before the split owned one share worth roughly $23 after the split. Though AIG hoped that a higher price would attract investors and reduce volatility, the stock continued to fall.

In the end, if you own a stock that splits, the value of your investment will remain the same.