When a stock splits, the price per share decreases according to the stock split ratio, and the number of shares outstanding increases. Stock splits do not affect retained earnings because it does not change the total value of the shares outstanding. Reverse stock splits decrease the number of shares outstanding and increase the price per share, but do not affect retained earnings.
When a company announces a stock split, it also announces the stock split ratio. For example, if a stock is splitting 2:1, it means that you will receive two new shares for every one old share of stock you owned before the split. One reason companies decide to split their stock is that their price per share is much higher than their specific industry’s average, making the stock unattractive to investors.
Retained Earnings and Stock Splits
Retained earnings are the profits a company makes that it does not distribute to the business owners or to its shareholders as dividends. Instead, the company retains the earnings to reinvest in the company itself. When a company sells new stock, it earns money and therefore increases retained earnings. When a company splits existing stock, it doesn’t make any money, so the split does not increase or decrease its retained earnings.
Stock Split Example
A stock split decreases the price per share according to the split ratio. For example, a company has 100 shares outstanding at $100 per share for a total common stock outstanding value of $10,000. The company decides to split the stock 4:1. This means that the company exchanges every existing $100 share for four $25 shares. The company now has 400 outstanding shares at $25 per share for an outstanding common stock value of $10,000. The split does not create equity and therefore, does not increase or decrease retained earnings.
Reverse Stock Splits
Reverse stock splits increase the price per share according to the reverse split ratio. The increase in price and the decrease in number of shares outstanding offset one another. The company makes no gain and it does not affect retained earnings. For instance, a company has 100 shares outstanding at $25 per share for a total outstanding common stock value of $2500. The company announces a reverse 1:2 split. Shareholders will receive one $50 share for every two $25 shares. The company now only has 50 shares outstanding at $50 per share for a total common stock outstanding value of $2,500. The reverse split did not create equity and does not affect retained earnings.