A stock split occurs when a corporation converts its shares into a multiple of its shares. A split is usually authorized in order to alter the price of a company's stock.
For example, if a business has 1,000 shares outstanding and triggers a one-for-five stock split, the 1,000 shares will be converted into 5,000 shares. Conversely, a reverse stock split will reduce the number of shares outstanding. For example, a five-for-one reverse split will convert 1,000 shares into 200 shares.
A stock split must be authorized in advance by the board of directors of a corporation.
There are several possible reasons for engaging in a stock split, which are as follows:
- Establish an issuance price. A company may be getting ready to go public, and its advisors are targeting a specific price point at which the shares should initially sell. This may require that the existing number of shares be reduced or expanded in order to achieve the targeted price. For example, if the estimated market value of a company is expected to be $150 million and the target price is expected to be $15 per share, then there should be 10 million shares outstanding. If there are currently one million shares outstanding, then each share should be split into 10 shares in order to have 10 million shares outstanding.
- Establish an affordable price. A company's share price may have crept higher over time, to the point where it is becoming difficult for an investor to purchase a single share. If so, a stock split will lower the price per share.
- Avoid penny stock status. If a company's share price has dropped below the minimum allowed price on the stock exchange on which its shares are listed, the exchange will issue a delisting warning. The company can engage in a reverse split to reduce the number of shares outstanding, thereby increasing the price per share for the remaining shares.
- Eliminate odd lot holdings. There may be a few shareholders whose holdings are inconsequential, usually less than 100 shares each. The issuing company must pay to have an annual report and other mailings sent to them each year, which can be expensive. To flush out these odd lot holdings, a reverse split can be used to reduce the holdings to less than one share each, at which point the company can cash them out.
Despite the number of reasons given, not that many stock splits occur. The reason is that shareholder approval may also be needed, which many organizations consider too difficult to bother with.
A stock split that results in additional shares outstanding is also known as a forward stock split.