Want to improve your trading strategies and your ability to spot opportunities? You need to know how different catalysts can move stock splits prices.
So let’s look at a specific catalyst: stock splits.
Stock splits can impact share prices in a big way. Understanding what stock splits are and how they affect stock prices can help you understand your trading options when this event occurs.
A stock split doesn’t directly impact a company’s value … but it can pave the way to a number of trading opportunities.
Let’s take a deep look at stock splits: what they are, real-world examples, and how you can use this information to help inform your trading decisions.
Stock Splits: The Basics
Stock splits happen when a company decides to increase or decrease the number of outstanding shares available to the public.
The company’s board of directors is responsible for choosing whether to split the shares.
As the total number of available shares increases or decreases, the dollar amount of each individual share will shift accordingly. But the total value of all combined shares remains the same.
This concept might be a little off-putting at first. Traders often associate rising or falling share prices with an increase or decrease in the company’s value, respectively.
But splits are really just about the per-share price, not the company value. And since the total value of the shares doesn’t change, the company’s value remains the same.
Types of Stock Splits
Let’s look at the two types of stocks splits you might see: Forward stock splits and reverse stock splits.
Each serves a different purpose and affects share prices differently. Let’s look at both and the implications of each, as well as why a company split its stock.
Forward Stock Split
Forward splits are the most common type of stock split. It’s where a company divides each share into multiple shares.
So, one share might be split into two, five, 10, or more shares, and each share would decrease in price. The result is an increase in the number of total outstanding shares with each share priced lower than before.
Why Companies Use Forward Stock Splits
Like I said, forward stock splits result in more shares at lower prices per share. But why would a company do this?
Typically, you’ll see a company choose to perform a forward split to make share prices more accessible — ahem, affordable — to buyers.
If a company’s stock price dramatically increases, fewer traders can afford shares. Splitting the shares and lowering the share price can increase the number of potential buyers.
Example
Let’s take a brief look at an example of a forward split…
Say Company A currently has 162 million outstanding shares, priced at $250 per share at market close.
Multiply 162 million by $250 for the company’s market cap: $40.5 billion.
To cut share prices, the company goes for a 5-for-1 forward split. Each share is split into five separate shares. Let’s run the numbers…
First, to get the total number of outstanding shares, multiply 162 million by five:
162,000,000 x 5 = 810,000,000
Company A now has 810 million outstanding shares. Now, to find the new per-share price, divide the original share price by five:
$250 / 5 = $50
Each share of Company A is now $50 instead of $250.
Even though the number of outstanding shares and the per-share price changed, Company A’s market cap remains the same.
$50 x 810,000,000 = 40,500,000,000
Using a forward split, Company A decreases its share prices, opening itself up to a larger pool of buyers and maintaining its market cap.
Reverse Stock Split
As you probably already guessed, reverse stock splits are the opposite of forward splits.
Instead of multiplying the number of shares, a reverse split reduces the total number of outstanding shares. This consolidation results in a greater per-share price without affecting the company’s value.
Why Companies Use Reverse Stock Splits
Why would a company perform a reverse split?
Companies usually do this for one of two reasons — to either avoid getting kicked off of major stock exchange or to get onto a major exchange.
The Nasdaq and NYSE, for example, each have a minimum security listing price. If a company’s per-share price drops below that mark or is in danger of doing so, they might perform a reverse split.
Reverse Split Example
Let’s see how this might play out…
Company B has 10 million outstanding shares with a per-share price of $1.50 at market close. This puts Company B’s market cap at $15 million.
To increase share prices, Company B performs a 1-for-5 reverse split.
So divide the original number of shares by the split number to get the new number of outstanding shares:
10,000,000 / 5 = 2,000,000
Company B now has only two million outstanding shares.
Now we calculate the new share price by multiplying the original share price by the split number:
$1.50 x 5 = $7.50
The two million outstanding shares now sell for $7.50 each.
Last, we can see that the company’s market cap is unchanged by multiplying the new share price by the new number of outstanding shares.
$7.50 x 2,000,000 = $15,000,000
Company B’s market cap is the same, and it now meets the requirements to be listed on major exchanges.
How Prices Stock Splits Impact Stock Prices
Neither forward nor reverse splits impact a company’s value. So, what’s the real impact?
Generally speaking, traders see forward splits as positive catalysts and reverse splits as negative catalysts.
Companies use forward splits to lower share prices and create more liquidity — more buyers can purchase shares of the given stock. When a stock is more accessible, it can create more demand and drive prices up.
On the other side, reverse splits can drive prices down.
Companies typically use reverse splits to increase share prices and stay on or get listed on a major exchange. But this often leads to poor reception from traders. The move is often seen as a desperate act by a poorly performing company trying to create an illusion of success.
It’s like when a failing company announces an IPO to gain funding and stay afloat. Traders usually recognize that the company is only doing so because it’s out of options.
Ultimately, forward splits often lead to upswings and reverse splits lead to downswings. But keep in mind that’s not always the case…
The stock market is unpredictable. You can use catalysts to make more informed decisions, but just because something is often the case doesn’t mean it’s always the case.
Remember to do your own research and perform thorough analysis before making a play on one catalyst.
Paul Scolardi’s SwingTrades Program
Understanding stock splits is a great start toward improving your ability to identify new opportunities and solidify your trading strategies.
But successful traders never stop learning.
I developed my SwingTrades program to help traders like you learn new strategies, spot future trends, and learn how catalysts like stock splits can create exciting new opportunities.
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How do you trade stock splits? Tell me your go-to strategy for this catalyst … Leave a comment below!
