A stock split occurs when a publicly traded company wants to decrease the price of stock shares. The total value of all outstanding shares or market capitalization of the company remains the same, and so does the stockholder percentage ownership in the company.
Companies split stock for many reasons. The most common reason to issue a stock split is when the dollar value per share of stock is too high and consumers are not attracted to the stock because of the price. A stock split increases market liquidity but does not change the actual value of the stock.
Types of Splits
Stock splits can be literal or reverse splits. A literal five-to-four stock split occurs when a company announces that it will convert five shares of outstanding stock to four shares. Reverse stock splits operate in the other direction, in that a four-to-five reverse stock split means the company will convert four shares of outstanding stock to five shares.
Assume a stockholder owns 100 shares of stock with a $50 per share value, and the company announces a five-to-four literal stock split. The stockholder current owns $5,000 worth of company stock, which is the stock price of $50 multiplied by the number of shares owned (100). To calculate the number of shares after the split, make the split of five to four a fraction of 5/4. Multiply the 100 shares currently owned times the fraction 5/4, which equals 125.
The stockholder now owns 125 shares of stock, but the total value of $5,000 has not changed. The individual share price changes with the stock split. The new share price is the value obtained by dividing the total value of the stock by the new share amount of 125. This calculates to $5,000 divided by 125, which equals a new individual share price of $40.