Stock Splits: What You Need to Know

Consider the following scenario: you have a $100 bill and someone offers you two $50 bills in exchange for it. Would you be willing to accept the offer and complete the trade? Due to the fact that most people are not enthused by a proposition such as this, it may appear that this is an insignificant question. Even after all is said and done, you will still end up with the same amount of money.

Stock splits are one example of a situation that can occur for people in the investment industry that is similar to this. For investors, however, a stock split is a far more exciting prospect than the hypothetical $100 scenario described above. The question is, however, how exactly they work, and, more importantly, are they worth all of the hype. In this article, we’ll look at stock splits, including why they happen and what it means for investors.

The Most Important Takeaways

  • A stock split occurs when a company decides to split its existing stock into multiple shares in order to increase liquidity.
  • Stock splits may also be implemented by companies in order to increase the attractiveness of their stock prices.
  • Because the split does not add any real value to the shares, the total dollar value of the shares remains unchanged.
  • The most common stock splits are 2-for-1 and 3-for-1, which mean that for every share held, a stockholder receives two or three additional shares, respectively.
  • A reverse stock split occurs when a company divides the number of shares that stockholders own, resulting in a rise in the stock market price as a result.

What Is a Stock Split and How Does It Work?

A stock split is a corporate action taken by the board of directors of a company to increase the number of shares that are currently outstanding. This is accomplished by dividing each share into multiple shares, thereby decreasing the stock price. A stock split, on the other hand, has no effect on the market capitalization of the company.

A $100 bill’s value does not change when it is exchanged for two $50 bills, and neither does the value of a $100 bill when it is exchanged for two $50 bills. Consequently, in a 2-for-1 stock split, each stockholder receives an additional share for each share of stock held, but the value of each share is reduced by 50%. This means that the value of two shares is now equal to the value of one share prior to the split.

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Consider the following scenario: stock A trades at $40 and has 10 million shares issued. This gives it a market capitalization of $400 million ($40 multiplied by 10 million shares) on the stock exchange. Following that, the company implements a 2-for-1 stock split. Shareholders will receive one additional share for each share they currently own. However, the stock price has been reduced by half, from $40 to $20, so they now have two shares for every one they had previously held.

It’s important to note that the market capitalization remains the same, despite the fact that the number of shares outstanding has doubled to 20 million, and the stock price has dropped by half to $20, for a total capitalization of $400 million. As a result, the true value of the company has remained unchanged.

Stock splits on a common stock basis

Stock splits can take on a variety of shapes and sizes. Stock splits are most commonly offered in the form of 2-for-1, 3-for-2, and 3-for-1 ratios. The new stock price can be calculated by dividing the previous stock price by the split ratio, which is a simple formula. When we divide $40 by two, we get the new trading price of $20, which is consistent with the previous example. If a stock undergoes a three-for-two split, we would follow the same procedure: 40/(3/2) = 40/1.5 = $26.67

Most of the time, reverse stock splits are implemented because the share price of a company has dropped significantly.

A reverse stock split is another option available to businesses. A one-for-ten split means that for every ten shares you own, you will receive one additional share. In the following section, we demonstrate exactly what effect a stock split has on the number of shares outstanding, the price of those shares, and the market capitalization of the company that is issuing the stock split.

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Stock splits are done for a variety of reasons.

There are a variety of factors that influence whether or not a company decides to split its stock. The first and most obvious reason is psychological. As the price of a stock rises inexorably, some investors may conclude that the stock is too expensive for them to purchase, while small investors may conclude that the stock is unaffordable.

The stock price is reduced as a result of the stock split to a more attractive level for investors. However, even though the stock’s actual value remains unchanged, the lower stock price may have an impact on how the stock is perceived, potentially attracting new investors. Additionally, splitting the stock gives existing shareholders the impression that they suddenly have more shares than they did previously, and of course, if the price of the stock rises, they will have more stock to trade.

Another reason, and perhaps a more logical one, is to increase the liquidity of a company’s stock. This increases in proportion to the number of outstanding shares of the stock. Stocks that trade for more than a few hundred dollars per share can have wide bid/ask spreads because of the volume of trade.

A perfect example is Warren Buffett’s Berkshire Hathaway (BRK.A), which has never had a stock split in the history of the corporation. Its bid/ask spread is frequently in excess of $100. As of March 2020, the class A shares were worth more than $257,500 per share. 1

None of these reasons or potential consequences are in accordance with financial theory, however. A finance professor will almost certainly tell you that splits are completely insignificant—yet companies continue to do so. Splits are an excellent demonstration of how corporate actions and investor behavior do not always follow the rules of financial theory and are subject to change. This very fact has paved the way for the development of a broad and relatively new field of financial study known as behavioral finance.

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Investors have a number of advantages.

There are a variety of viewpoints on whether stock splits benefit or disadvantage investors. One school of thought holds that a stock split is a good buying indicator, indicating that the company’s stock price is rising and doing well. However, while this may be true, a stock split has no effect on the fundamental value of a company’s stock and provides no real benefit to shareholders.

This is despite the fact that investment newsletters are typically attentive to the generally positive sentiment surrounding a stock split. In fact, there are entire publications devoted to keeping track of stocks that split and attempting to profit from their bullish nature. 2 Some critics argue that this strategy has not been tried and tested over time and is only marginally successful at best, if at all.

Commissions are taken into consideration.

Due to the fact that commissions were weighted according to the number of shares purchased in the past, purchasing before the split was a good strategy. It was beneficial only in the sense that it saved you money on commission fees. This is no longer a significant advantage because most brokers now charge a flat fee for commissions. They charge the same amount regardless of how many shares you trade (10, 100, or 1,000).

What’s the bottom line?

It is not advisable to purchase a company’s stock solely for the purpose of participating in a stock split. While there are some psychological reasons for companies to split their stock, the fact that they do so does not change the fundamentals of the business. Always keep in mind that the split has no impact on the company’s value as measured by its market capitalization. At the end of the day, whether you have two $50 bills or a single $100 bill, you will have the same amount of money in your account.

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