What is a Stock Split?

30
December

Let’s say you have a $100 dollar bill and I want to swap you two fifties for it. Would you accept the offer? As nonsensical a question as it is, this is a question that will help you understand the nature of a stock split.
So what exactly is a stock split? A stock split is an action undertaken by a corporation that enlarges the number of outstanding shares by dividing each share, which diminishes the price of the share. However, the stock’s market capitalization remains the same, just as the $100 dollar bill retained its values despite being traded for two $50 dollar bills. This would be called a 2-for-1 stock split. In a 2-for-1 stock split, each stockholder receives one additional share of equal value for every share they hold. However, the value of each share is reduced by half. Instead of one share equaling a given amount, the combine value of both shares is equal to the single share previously held.

Let’s use an example. Let’s say that person X is trading at $60 and has 10 million shares issued. As of right now, the market capitalization of the shares that person X holds is $600 million ($60 per share x 10 million shares). The company person X has invested in decides to do a stock split. For each share that person X holds, they will receive an additional share. However, all their shares will be reduced by 50%. So: $30 per share with 20 million shares. This equals out to $600 million, the same combined value their shares had prior to the stock split. Their market capitalization is the same.
The most common types of stock splits are 2-for-1, 3-for-1, and 3-for-2. An easy way to determine what the price of each share will be after the stock split is to divide the previous stock price by the current stock split ratio. So to use our above example: $60 per share multiplied by ½, or $60(1/2). This, in turn, equals $30, the price of each share after the stock split. If it is a 3-for-2 split, $60(3/2) equals $90 per share.
There is also such a thing as a reverse stock split meaning that in a 1-for-10 stock split, each share will be worth the price of ten.
So what is the point of a stock split? There are several reasons why corporations decide to do a stock split.
The first reason is a psychological one. As the price of stock climbs higher and higher, the price of the stock will get too high and some investors may feel the price is too high to buy and small business may see the stock as unaffordable. By splitting the stock, the price per share is brought to a lower and, to some investors, more affordable price. Also, splitting stock gives the existing shareholders the feeling of having more stock. Of course, if the price per share rises, they have more stock to trade.
Another reason is to increase the stocks liquidity: the higher the number of outstanding shares, the higher the liquidity. When stocks get into a high price range, this can result in very large bid/ask spreads. By splitting shares, a lower bid/ask spread is achieved which raises liquidity.
Stock splits do not result in the decrease of your shares. The total value of all your shares is not affected in any way. This should not detour you from investing in stock, not should it be your sole reason for investing in stock.

This post was written by

jason – who has written posts on Budget Clowns.
Father of three and married to a lovely women. Always looking for ways to save money, and invest it properly for my children's future.

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