What Is A Stock Split?

Stock splits are one of the least understood actions of the stock market. Many new investors mistakenly believe that when a stock splits it gives the stock holder twice as many shares as before at twice the value. While the stocks do split, increasing the number of shares, what is often not understood is that the value of each of those shares is reduced. For example, if a corporation decides to split its stock 2-for-1, it issues one new share for each outstanding one. At the same time, the value of each share is cut in half. So the stock holders now hold twice as many shares but the total value is the same as before the split. A stock split is like receiving 2 five-dollar bills for a single ten-dollar bill. Same value – twice as much paper.

What would lead a company to do this?

Much of the motivation behind stock splitting is investor psychology. A stock's price per share may be so high that is actually provides a barrier to investors because they feel it is beyond their reach. A stock split, however, reduces the price of that stock, making it more affordable to smaller investors. The reality of the situation, though, is that the investor could have bought fewer pre split shares at the same price. The bargain, though, is more tempting, as a $20 dollar stock has more appeal than the $60 stock for some investors.

Stocks can be split in a variety of different ratios, but the most common are the 2-for-1, 3-for-2, and 3-for-1. A company can also reduce the number of outstanding shares, resulting in each stock holder owning fewer shares. This is referred to as a reverse split. Reverse stock splits are not as common but are used by companies for several reasons. The price per share may be so low that investors may view it is a poor investment. Another reason is that the company may be attempting to prevent the possibility of becoming delisted on the stock exchange. A third reason for a reverse split is to push out minority stockholders or for the company to go private.

Advantages

Stock splits are advantageous to a company - and to the investor - in several ways. The lower prices per share can result in greater liquidity. It is easier to sell stocks when they are lower in price and there is not as much of a bid/ask spread (the difference between buying and selling prices). This holds particularly true for stocks that are priced at hundreds of dollars. The smaller investors feel that these stocks are beyond their budget while high bid/ask spreads can turn off the larger investors.

Investor psychology is another great advantage of stock splits. A split is generally viewed as an indication of a bullish market meaning that the stock prices are on the rise, translating that the company itself is doing well financially. When a stock splits, there is usually a short term rise in value, but in a short period of time the market usually normalizes and the value drops somewhat. One disadvantage of a split is that it can create a false perception of a company in the eyes of the investor, causing them to expect more from a company's performance. When these performance expectations are not met, investor confidence could be shaken and this can result in a drop in prices per share.

A stock split does not affect the value, worth or performance of a company. While the increase in the number of shares may seem appealing, in the end your 2 five-dollar bills are still worth the same as your ten-dollar bill.