The mere mention of a stock split can get an investor's blood rushing. But are they worth all the excitement? It depends on why they happen and what it means to the investor.
Say you have a $100 bill and someone offers you two $50 bills in exchange . Most people won't get excited over a proposition like this because you still end up with the same amount of money. Stock splits present similar situations for people in the investment industry.
Key Takeaways
- In a stock split, a company divides its existing stock into multiple shares to boost liquidity.
- Companies may also do stock splits to make share prices more attractive.
- For shareholders, the total dollar value of their investment remains the same because the split doesn't add real value.
- The most common splits are two-for-one or three-for-one. A stockholder gets two or three shares respectively for every share held.
- A company divides the number of shares that stockholders own in a reverse stock split, raising the market price accordingly.
What Is a Stock Split?
A stock split is a corporate action by a company's board of directors that increases the number of outstanding shares. It's accomplished by dividing each share into multiple shares, diminishing its stock price.
A stock split does nothing to the company's market capitalization. This figure remains the same. Each stockholder receives an additional share for each share held in a two-for-one stock split but the value of each share is reduced by half. Two shares now equal the original value of one share before the split.
Let's say Stock A trades at $40 and has 10 million shares issued. This gives it a market capitalization of $400 million or $40 x 10 million shares. The company then implements a two-for-one stock split. Shareholders receive another share for each share they currently own.
Now they have two shares for each one previously held but the stock price is cut by 50% from $40 to $20. The market cap stays the same, doubling the number of shares outstanding to 20 million and simultaneously reducing the stock price by 50% to $20 for a capitalization of $400 million.
The true value of the company hasn't changed at all.
Common Stock Splits
Stock splits can take many forms but the most common are two-for-one, three-for-two, and three-for-one. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. Using the example above, divide $40 by two to get the new trading price of $20. Do the same for a three-for-two split: 40/(3/2) = 40/1.5 = $26.67.
Reverse stock splits are usually implemented because a company's share price loses significant value.
Companies can also implement a reverse stock split. A one-for-10 split gives you one share for every 10 shares you own.
This is the effect a split would have on the number of shares, share price, and the market cap of the company doing the split:
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Reasons for Stock Splits
Companies consider carrying out a stock split for several reasons. The first is psychology. Some investors may feel that the price is too high for them to buy as the price of a stock gets higher and higher but small investors might feel that it's unaffordable. Splitting the stock brings the share price down to a more attractive level. The actual value of the company doesn't change but the lower stock price may affect the way the stock is perceived and this can entice new investors.
Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before. They have more stock to trade if the price rises.
Another reason companies consider stock splits is to increase a stock's liquidity. With a lower price, more shareholders can afford to invest in high-value companies, ultimately increasing the market for that company's stock. Stocks that trade above hundreds of dollars per share can result in large bid/ask spreads.
None of these reasons or potential effects agree with financial theory, however. Splits are irrelevant yet companies still do them. Splits are a good demonstration of how corporate actions and investor behavior don't always fall in line with financial theory. This has opened up a wide area of financial study called behavioral finance.
Advantages for Investors
There are plenty of arguments over whether stock splits help or hurt investors. One side says a stock split is a good buying indicator, signaling that the company's share price is increasing and doing well. This may be true but a stock split simply has no effect on the fundamental value of the stock and poses no real advantage to investors.
Investment newsletters nonetheless take note of the often positive sentiment surrounding a stock split. Entire publications are devoted to tracking stocks that split and attempting to profit from the bullish nature of the splits. Critics would say this strategy is by no means a time-tested one and is questionably successful at best.
Factoring in Commissions
Buying before a split was historically a good strategy due tocommissionsweighted by the number of shares you bought. It was advantageous only because it saved you money on commissions. This isn't such an advantage anymore because most brokers offer a flat fee for commissions. They charge the same amount whether you trade 10 or 1,000 shares.
What Are Outstanding Shares?
Outstanding shares are those that are currently owned by someone or something other than the company itself. They're held by the public, either through individual ownership or as components of a pension fund or mutual fund. Individual owners can be officers or employees of the company.
The company can no longer issue or sell these shares because they're held by someone or something else.
Why Would a Company Do a Reverse Stock Split?
Companies typically do reverse stock splits to attract new investors. They tend to occur because companies believe their stock price is too low. Dividing the number of shares that stockholders own will proportionately raise the market price. Companies that perform this tactic are often smaller entities that trade in over-the-counter markets rather than on the major U.S. stock exchanges.
What Is a Class A Share?
Some companies issue shares of common stock divided into two or more classes, although approximately 90% issue only one class. The classes award different voting rights. Class A shares can award 10 votes per share compared to Class B shares which have only one vote per share.
The Bottom Line
A stock split increases the number of shares a company has, but it doesn't automatically make anyone any richer. There are some psychological reasons why companies split their stock but the business fundamentals remain the same. However, the psychological value of a stock split can increase interest in the company's equity.
