Stock Splits 101

How This Corporate Action Affects Market Capitalization and You

Stock Splits 101
July 21, 2014

Companies with stock that is trading at a relatively high price may decide to execute a stock split. Stock splits are when a company issues new stock and adjusts the price of the total stock (existing plus new issues) to the same cumulative value as before the split.

For example, if you had 100 shares of a stock worth $500 each and the company issued a 2-1 stock split, you would have 200 shares of company stock that are worth $250 each after the split. You, and all the other stockholders, still have the same value of stock as you had before ($50,000 in this case).

What effect does a stock split have on market capitalization? Absolutely none. If we took a $20 bill out of your wallet and gave you two $10 bills, you would still have the same amount of money – just as if you had a $20 stock that split 2-1. In the end, you will have two pieces of stock worth $10.

However, there is a significant difference – a $20 bill is always worth $20, but stocks have different values over time because their value (and therefore price) is determined by demand. If a stock price reaches heights that are beyond the purchase capability of the average investor, a stock split theoretically brings the price down to where investors of lesser means can afford shares – therefore increasing demand.

Does that theory work? Sometimes it has an impact, but fundamentals of the stock -- and conditions within a given sector or the broader marketplace -- are what chiefly drive any stock’s price Nevertheless, a stock split implies a strong, growing company, and leaves a generally positive perception on the market. A stock split creates inexpensive positive marketing.

Aside from the perception of success for the company, there is also a tangible psychological effect with investors owning more shares. Apparently, you may not care whether you have three $20 bills or six $10 bills in your wallet, but you are happier owning six shares of $10 stock than you are with three shares of $20 stock.

The growth rate of the company will be the same either way, but people tend to think the new diluted stock will eventually reach the original higher price. They may be inclined to buy even more of the stock because of its new "bargain" status.

The other primary reason that companies engage in stock splits is to increase liquidity. An increased pool of potential (and presumably motivated) buyers that can now afford the stock increases the liquidity of the stock should you need to sell any shares.

In essence, all the reasons for issuing stock splits are psychological in nature. Not all companies play this game – the most famous stock never to split is Warren Buffett's Berkshire Hathaway stock (NYSE: BRK-A), which at the time of this writing is trading over $190,000 per share. On the other hand, Apple (NASDAQ: AAPL) just had a 7-for-1 stock split after splitting 2-1 in 1987, 2000 and 2005. That means a shareholder who owned 100 shares in early 1987 and hasn’t sold any now holds 5600 shares. Rumor has it that with a share price around $100, Apple is now poised to become one of the 30 stocks included in the Dow Jones Industrial Average.

Does it ever work in reverse? Yes, it does, and it means bad news. A reverse stock split occurs when a company calls in stock to raise the value per share of the remaining stock. Typically, this means shares have fallen so far that the stock could be in danger of being delisted by the exchange on which it trades.

So if one of the stocks in your holdings decides to split, celebrate the fact that the company is strong enough to split, but don’t get carried away. It may make sense to purchase more of the stock, but look carefully at the fundamentals of the stock before making your purchase and leave the "irrational exuberance" to others.

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