Understanding Split Stocks: What is it all about?

Understanding Split Stocks: What is it all about?

Let’s say you had a $100 bucks and someone offered you two $50 bills for it. Would you accept his/her offer? The question might seem ridiculous and pointless, but the action of a stock split puts you in the same position. Now, if you have company and the board wants to split the stock, would you do it? This article will explore what is a stock split all about, why some companies do it, and its benefits and drawbacks.

What Is a Stock Split?

A stock split is a corporate action that increases the number of the corporation’s outstanding shares by dividing each share. In turn, it diminishes its price.  However, the stock’s market capitalization stays the same, just like the value of the $100 bill does not change if it is exchanged for two $50s.

A stock split is also known as a forward stock split. In the UK, a stock split is referred to as a scrip issue, bonus issue, capitalization issue, or free issue.

Although the number of outstanding shares increases by a specific multiple, the total dollar value of the shares stays the same compared to pre-split amounts, because the split does not add any real value.

For example, in a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share decreases by half: two shares now equal the original value of one share before the split.

Example of a Stock Split

For example, stock A is trading at $40 and has 10 million shares issued, which gives it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to implement a 2-for-1 stock split.

For each share shareholders currently own, they receive one additional share, deposited directly into their brokerage account. They now have two shares for each one previously held, but the price of the stock gets cut by 50%, from $40 to $20.

Notice that the market capitalization stays the same. It has doubled the amount of stocks outstanding to 20 million while simultaneously reducing the stock price by 50%. Basically, the true value of the company hasn’t changed at all.

The most common stock splits are, 2-for-1, 3-for-2 and 3-for-1. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. In the case of the example, divide $40 by 2 and we get the new trading price of $20. If a stock were to split 3-for-2, we’d do the same thing: 40/(3/2) = 40/1.5 = $26.6.

Why Do a Stock Split?

A stock split usually occurs in companies that have seen their share price increase to high levels or are beyond the price levels of similar companies in their sector. The primary reason is to make shares seem more affordable to small investors even though the underlying value of the company has not changed. This has the practical effect of increasing liquidity in the stock.

When a stock splits, it can also result in a share price increase following a decrease immediately after the split. Since many small investors think the stock is now more affordable, they end up boosting demand and drive up prices. Another reason for the price increase is that a stock split provides a signal to the market that the company’s share price has been increasing and people think this growth will continue in the future, and again, lift demand and prices.

What’s The Point of Splitting Stocks?

There are several reasons companies consider carrying out a stock split. The first reason is psychology.

As the stock price gets higher, some investors may feel the price is too high for them to buy. Also, small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more “attractive” level. The effect here is purely psychological.

The stock value doesn’t change one bit, but the lower stock price may affect the way the stock is perceived. Therefore, it entices new investors. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before. Of course if the prices rise, they have more stock to trade.

Another reason, and arguably a more logical one, for splitting a stock is to increase a stock’s liquidity. That’s because it increases with the stock’s number of outstanding shares.

When stocks get into the hundreds of dollars per share, very large bid/ask spreads can result. A perfect example is Warren Buffett’s Berkshire Hathaway, which has never had a stock split. Its bid/ask spread can often be over $100, and as of November 2013, its class A shares were trading at just over $173,000 each.

However, none of these reasons or potential effects agrees with financial theory. If you ask a finance professor, he or she will likely tell you that splits are totally irrelevant. Nonetheless, companies still do split their stocks. Splits show how the actions of companies and the behaviors of investors don’t always fall in line with financial theory. This actual fact has opened up a wide and relatively new area of financial study called behavioral finance

A digital screen showing different figures that indicate stock prices.

How About a Reverse Stock Split?

Another version of a stock split is the reverse split. Companies typically use this procedure with low share prices that would like to increase these prices to either gain more respectability in the market or to prevent the company from being delisted (many stock exchanges will delist stocks if they fall below a certain price per share).

For example, in a reverse 1-for-5 split, 10 million outstanding shares at 50 cents each would now become 2 million shares outstanding at $2.50 per share. In both cases, the company is still worth $5 million.

Benefits and Drawbacks of Stock Splits

Benefits

  • Price

Some investors are afraid of high-priced stocks, especially those stocks that are priced over $100 per share. They would rather buy 100 shares at $50 each than 50 shares each priced at $100, though there is no economic difference between the two. Even the commissions are the same.

Companies know this preference for lower prices and offer stock splits to make their stock prices “friendlier” to small investors. Split stocks supposedly benefit from increased “liquidity,” the ability to sell stock without affecting its price.

  • Signal

While economists may see stock splits as a neutral occurrence, some advisers tout them as a bullish signal and encourage investors to buy stocks that are about to split. There is some evidence that stock prices do temporarily increase right after a split.  But the same studies show that the effect fades quickly.

Nonetheless, corporations may use stock splits to signal that their businesses are doing well. Once again, this benefit is more psychological than financial.

  • No Reverse Split

While stock splits are probably neutral, reverse splits, where many old shares turn into fewer new shares, is certainly negative. It signals that a stock price has fallen to an “unrespectable” level. A reverse split calls attention to a stock price decline. It also raises a lot of questions regarding the reason why the price is so low.

The stock exchange delist a stock that is below $5 per share. Thus, that would severely handicap the company’s ability to raise new equity funding.

  • Long Run

Owning shares that have a recurrent pattern of growing and splitting is one of the most rewarding investments.

For instance, take a stock with a history of climbing following a split to around $64 from $32. A person who starts with 1,000 shares at $32 and rides out the two-year cycle ends up with 2,000 shares. Also, the shares represent the same total value as before the split.

Understanding Split Stocks - What is it all about and why do it (2)

Drawbacks

  • Easier Sell

Lower price stocks are psychologically easier for shareholders to sell. As share prices rise, investors perceive the value of each share as being great. They also tend to associate a high price with successful company management and growth. Once share prices drop after a split, more impulsive selling commonly occurs.

  • Record-Keeping

Over time, stock splits create record-keeping challenges for company accountants, analysts, and shareholders. A typical historical chart shows how a share price rises and falls over time. When you split a stock, the chart would obviously reflect the quick drop in share price.

  • Low-Price Risks

Normally, companies split stocks when things are going well and the share price is on the rise. But an excessively aggressive split may lead to risks if the share price falls too much going forward.

  • Costs

For the company, splitting stock is not free. Stock splits result from either a board of directors meeting and decision or a vote of shareholders. Either approach has costs. Also, the company must meet listing exchange and legal requirements by letting shareholders know its date and effects.

See Also: Penny Stocks 101: What Are They About?

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