Rising stock prices are usually a good thing, but what happens when share prices exceed the budget of most investors? Many companies choose to undergo a 2-for-1 stock split, which effectively reduces the price of each share without actually devaluing the company itself.
What is a 2-for-1 stock split? Are these shares worth pursuing? In this guide, you’ll learn more about stock splits and how they might impact your investment planning.
What Is a 2-for-1 Stock Split?
Imagine, for a moment, that you’re the CEO of Company A. At your Initial Public Offering (IPO), your company’s shares were trading at $10 per share. Fast forward a decade or so, and your considerable success has boosted your share price to $100 per share.
On the one hand, you’ve increased your company’s market value tenfold. But there’s just one problem: not many investors are willing to fork over $100 for a share in your company. What can you do?
A stock split allows a company to divide every single share of stock into multiple shares. What does a 2-for-1 stock split mean? In a 2-for-1 stock split, each share is split into two, and the combined voting power and market value of these two shares are equal to the power and value of one share prior to the split.
To continue the above example, Company A can undergo a 2-for-1 stock split, which means that each of its shares is now worth $50. Investors who previously held one share valued at $100 now hold two shares valued at $50 each.
How Does a 2-for-1 Stock Split Work?
In the above example, notice that the value of the stock doesn’t change. Instead, the total number of shares increases. In a 2-for-1 stock split, the total number of shares of company stock doubles, and the value of each share is cut in half.
Thankfully for current investors, this doesn’t change the total value of their investment. It simply means that they have more shares of stock in the same company than they did before, though since the company’s shares have increased across the board, it also doesn’t change the percentage of the company they own.
For new investors, a 2-for-1 stock split lowers the price of each share, which can make it easier to invest in a given company. If investors have been leery of investing in a full share of a top-performing company, a stock split can put ownership within easier reach.
Examples and Types of Stock Splits
In a 2-for-1 split, the number of shares doubles, and the share value is cut in half. But a 2-for-1 stock split is not the only type of stock split you might encounter.
Other common types include a three-for-one split, where investors receive three shares for every share they currently have, and the price per share is reduced to one-third of the previous value. A three-for-two split will replace every two shares of current stock with three shares, this time with a smaller reduction in price.
While these are common, many types of stock splits can occur. The Apple corporation, for example, has undergone numerous stock splits over the years, including a 7-to-1 split in 2014 and a recent 4-to-1 split in 2020.
Stock Splits vs. Fractional Shares
Many investors may already be familiar with “fractional shares.” Fractional shares allow you to own a portion of a stock share, which can be beneficial when the price of the entire share is high.
However, fractional shares can also result from certain types of stock splits. In a 3-for-2 split, for example, investors with an odd number of shares might find themselves with a remainder from the split.
Trading fractional shares can be tricky. Investors generally prefer trading whole shares, and only a major brokerage firm will help you trade fractional shares at all. This hassle is actually why stock splits occur in the first place — to allow investors to jump on board and purchase whole shares of company stock rather than fractional shares.
Advantages of 2-for-1 Stock Splits
What does a 2-for-1 stock split mean for your investment portfolio? There are many pros and cons of stock splits. Some of the advantages of a stock split include:
Raises Share Price
It may sound counter-intuitive, but a 2-for-1 stock split can potentially raise the share price. How? While the split has the immediate effect of lowering the price for each share, the lower price can attract new investors, thus raising the company’s value.
According to research from Nasdaq, stocks that had recently split outperformed the market by 4.8% for the year following the split.
Makes It Easy for Investors to Balance Their Portfolio
Imagine that your portfolio contains shares of stock valued at $100 each, sitting next to shares of stock valued at only $20 or $30. This setup can create a lack of balance in your investments, which becomes all the more noticeable if you ever sell those high-value stocks.
Stock splits make it easier to balance your portfolio, and you’ll also have an easier time selling shares of high-priced stock to rebalance your portfolio over time.
Lowers the Cost of Put Options
As an investor, you may already be familiar with stock put options. These options give buyers the ability to sell shares at an agreed-upon price.
But high-price stocks can make it challenging to fulfill this obligation. When stocks trade at a lower price per share, it becomes easier to sell put options since each “lot” (a bundle of shares) is more affordable.
Disadvantages of 2-for-1 Stock Splits
Unfortunately, 2-for-1 stock splits have some disadvantages. These include:
No Guarantee of Increased Share Price
Yes, stock splits can increase the share price, but this is a secondary effect of the split, and there’s no guarantee that prices will actually rise.
Stock Splits Increase Volatility
While stock splits increase liquidity, they also increase volatility. This volatility can artificially alter the market value of the stock, which can make it harder for investors to assess their potential investment.
What Are Reverse Splits?
As an investor, you’ll want to avoid companies that undergo a “reverse split.” Here’s why.
A reverse split usually occurs when the company’s share prices are dropping so low that they’re in danger of being delisted from a major stock exchange. A reverse split effectively merges shares together, reducing the number of available shares and boosting the price per share.
This tactic might simply be masking a company’s poor performance. Unless the company has a solid plan for turning things around, these are investments to avoid.
Alternatives to Stock Splits
Some companies see their share price soar without ever undergoing a stock split. The investing giant Warren Buffet is known for never splitting the shares of Berkshire Hathaway, and its class A shares are currently valued at nearly $440,000.
Buffet pioneered the concept of a special Class B share, which trades at a mere fraction of the price of class A shares. As of August 2022, these Class B shares traded at only $292 per share.
This dual-class structure is an alternative to stock splits and allows a company to retain its considerable value while still making its stock shares accessible to the average investor.
Not all companies offer this dual-class structure, which is why it’s still helpful to look for companies like Apple that undergo regular splits.
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