A stock split occurs when a company exchanges its existing shares for new shares of stock without impacting the company’s capitalization or the value held by each shareholder.
The most common stock split is a 2-for-1 split, meaning that a shareholder owning 100 shares valued at $50 per share before the split would own 200 shares valued at $25 per share after the split. Before the split, the shareholder's stock value equaled $5,000 (100 x $50) and after the split, the shareholder still owned stock valued at $5,000 (200 x $25). A stock split does not add any value to the holdings. A 3-for-1 stock split means the shareholder would receive three shares for every share owned before the stock split.
A stock split does not change the company’s total capitalization, or market value. Suppose Zoey’s Bones has one million shares outstanding. Just prior to the split, each share was valued at $300. Zoey’s Bones would have a market capitalization of $300 million (1 million shares x $300 per share). The board of directors decides to have a 3-for-1 stock split. The number of outstanding shares would increase to three million, and the share price would adjust to $100. Zoey Bones would still have a market capitalization of $300 million (3 million shares x $100 per share).
Why would a company choose to split its stock if the market value does not change? A stock split increases the stock’s liquidity by increasing the number of shares outstanding. A company may feel a stock’s high price may prevent investors from investing in their company. For example, Tesla's common shares sold for over $1,500 in July 2020. Management believed the price discouraged employees and investors and chose to have a 5-for-1 stock split.
A stock split that increases the number of outstanding shares is a forward split. Occasionally companies will reduce the number of outstanding shares and increase the stock price by using a reverse stock split. Like forward splits, the total value a shareholder owns of a particular stock is unchanged and the company’s market capitalization is also unchanged. For example, an investor owning 200 shares valued at $10 per share would own 100 shares valued at $20 following a 1-for-2 reverse split. The value of the shareholder’s shares would be $2,000 before and after the reverse split. A company may exercise a reverse split if its shares fall sufficiently to jeopardize the stock’s listing on an exchange.