When a company splits its stock, it increases the number of shares outstanding and decreases the price per share. The number of the shares investors own increases, but the total value of their shares does not change because the split decreases the price per share according to the split ratio. An easy way to remember how a split works is to think of it like exchanging one dime for two nickels. If those coins were stock, the split ratio would be 2:1 or two-for-one. After the split, the total value of your money is still 10 cents but instead of one coin worth 10 cents, you now have two coins worth 5 cents each.
Companies may choose to split its stock if the current stock price is too high, especially if the price is significantly higher than other companies in the same market sector. In this case, investor demand decreases. Splitting helps increase demand because it reduces the price per share. Companies may also decide to split its stock to increase its liquidity. When the stock splits, it decreases the bid-ask spread. When the bid price—what investors are willing pay for the stock and the ask price—the price at which investors are willing to sell the stock are closer together, more stock is bought and sold, which increases the stock’s liquidity.
A split ratio is the number of new stocks investors receive for every one stock they currently own. If the stock split ratio is 3:2, investors receive one additional share for every two shares they own. Reverse stock splits decrease the number of shares you own. If a reverse split ratio is 1:5, then the company takes four shares for every five shares you own.
Calculating Split Ratios
There is no formula for calculating how many shares you receive in a split. A quick way to determine how many shares you receive in a split is to make the two sides of the ratio even. In a 3:2 split, you have to add one additional share to the right hand side of the ratio to make both sides even. You receive one additional share in a 3:2 split. If the split is 5:1, you have to add four additional shares to the right hand side of the ratio to make both sides even. You receive four additional shares for every one share you currently own.
Price Per Share
The formula to calculate the new price per share is current stock price divided by the split ratio. For example, a stock currently trading at $75 per share splits 3:2. To calculate the new price per share: $75 / (3/2) = $50. If you owned two shares before the split, the value of the shares is $75 x 2 = $150. You received one additional share after the split, but the price per share dropped to $50. The value of your shares has not changed because $50 x 3 = $150.