Stock Splits and Reverse Splits

Now that you know the types of corporate actions, let's look at the most commonly tested one: stock splits. The exam frequently tests your ability to calculate post-split shares and prices.

Forward Stock Splits

A forward stock split increases the number of shares and decreases the price per share proportionally.

• Total investment value does NOT change (this is the most important point)
• The company is dividing its existing shares into more pieces
• Common split ratios: 2-for-1, 3-for-1, 3-for-2

Think of it this way: Picture a pizza cut into 4 slices versus 8 slices. With 8 slices, each piece is smaller, but you still have the same amount of pizza. A forward split works the same way: more shares, each worth proportionally less, but your total value stays constant.

Example: 2-for-1 split

• Before: 100 shares at $80 each = $8,000 total value
• After: 200 shares at $40 each = $8,000 total value
• Each share becomes 2 shares, each worth half as much

Example: 3-for-2 split

• Before: 200 shares at $60 each = $12,000 total value
• After: 300 shares at $40 each = $12,000 total value

Why companies split stock:

• Make shares more affordable and accessible to retail investors
• Increase liquidity (more shares trading in the market)
• Does NOT create new value or generate income for shareholders
• A forward split is NOT a taxable event

Exam Tip: Gotchas

• Stock splits do NOT create value or income. The total investment value stays the same. If an answer choice suggests a split creates a taxable event or increases total portfolio value, it is wrong.
• A 3-for-2 split is a common test calculation. 200 shares at $60: new shares = 300, new price = $40 (total still $12,000). Multiply shares by the ratio (200 x 3/2), divide price by the ratio ($60 / 3 x 2).

Reverse Stock Splits

A reverse stock split decreases the number of shares and increases the price per share proportionally.

• Total investment value does NOT change (same principle as forward splits)
• The company is combining multiple shares into fewer shares
• Common ratios: 1-for-5, 1-for-10, 1-for-4

Example: 1-for-5 reverse split

• Before: 500 shares at $2 each = $1,000 total value
• After: 100 shares at $10 each = $1,000 total value
• Every 5 shares become 1 share, worth 5 times as much

Why companies do reverse splits:

• Meet exchange minimum listing price requirements (e.g., $1.00 minimum on NYSE and Nasdaq)
• Avoid being delisted for trading below the minimum price
• Reduce the total number of shares outstanding
• Often viewed negatively by the market (signals the stock has been declining)

Fractional shares: If a reverse split leaves a shareholder with a fractional share (e.g., owning 7 shares in a 1-for-5 reverse split), the company typically pays cash for the fractional portion rather than issuing a partial share.

Exam Tip: Gotchas

• Reverse splits are a negative signal. They are typically done to avoid delisting, which means the stock has been declining. A higher post-split price does not mean improved company performance.

Impact on Cost Basis and Open Orders

Stock splits adjust the cost basis per share but NOT the total cost basis:

The math shortcut:

• Forward split: Multiply shares by split ratio, divide price by split ratio
• Reverse split: Divide shares by split ratio, multiply price by split ratio
• Total value always stays the same

Open orders and options contracts must be adjusted after a split to reflect the new share count and price. For example, after a 2-for-1 split, a call option for 100 shares at a $50 strike price becomes an option for 200 shares at a $25 strike price. The total contract value remains the same.

Exam Tip: Gotchas

• Cost basis per share changes, but total cost basis does not. This is a frequently tested distinction.
• Open orders are canceled or adjusted after a split. Existing limit and stop orders must be recalculated to reflect the new price per share.