Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Stock Split

What it is:

A stock split is a procedure that increases or decreases a corporation's total number of shares outstanding without altering the firm's market value or the proportionate ownership interest of existing shareholders. This action, which requires advance approval from the company's board of directors, usually involves the issuance of additional shares to existing stockholders.

How it works (Example):

Before announcing a stock split, a firm's board of directors must first decide on a distribution rate. Typically expressed as a ratio (such as 2-for-1, 3-for-1, etc...), this distribution rate will determine exactly how many shares of stock the firm hands over to its existing shareholders.

Let's assume XYZ Corp, which has two million shares outstanding, is trading for $30. In this case, the firm's total market value, or market capitalization, is $60 million (2 million x $30/share). After a two-for-one stock split, the firm's number of shares will double to four million, while the value of those shares will be cut in half to $15. However, the company's total market capitalization will remain the same at just $60 million (4 million* $15/share).

Taken from another perspective, let's suppose you held 100 shares of XYZ before the split. Prior to the split this total position would have been worth $3,000 (100*$30/share). After the split takes place you will then hold twice as many shares (200 shares), but the firm's share price will be cut in half to $15. The net value of your position will remain unchanged at $3,000 (200*$15/share).

In the end, splits accomplish little more than simply slicing a pie into thinner pieces. Though an investor may acquire more of those slices, or shares, after a split, neither the company's value nor his/her ownership interest will materially change.

Why it Matters:

If the net effect to current shareholders is zero, then why do companies choose to split their stock? Typically, a firm's board of directors decides to split its stock in an effort to reduce its share price. After all, high prices can act as a deterrent to prospective buyers -- particularly smaller ones. A stock split will reduce a company's share price to a level that is hopefully seen as more affordable to a broader range of investors.

The point at which management decides to institute a split is also fairly arbitrary, as some companies routinely split their stocks at $50/share, while others may wait until prices exceed $100. Some firms, such as Wal-Mart (WMT), have historically split their shares frequently. Meanwhile, others have done so sparingly. Berkshire Hathaway (BRKa), run by famed investor Warren Buffett, has never completed a stock split. As a result, the company's shares now trade for tens of thousands of dollars each.

Certainly, most companies prefer that to keep their share prices at a much more affordable level. The goal here is to make their stock accessible to as many investors as possible. Of course, companies also do not want their shares at the other extreme either. When a company's shares languish in so-called "penny stock" range, trading for only a few dollars per share (or even less in many cases), they usually fall below the radar screens of institutional investors. Not only will the company likely lose analyst coverage, but if its share price falls too far the firm might also run the risk of being de-listed from whatever exchange it is traded on. (Most exchanges have certain share price requirements that companies must meet in order to stay listed.) Troubled firms stuck in this position will sometimes employ a reverse split. Though the move will not increase the company's overall value by a single penny, it will lift the firm's shares to what is generally regarded a more respectable price range.