What is a Stock Split

If a publicly-traded company decides that its stock is priced too high for the average buyer, it may decide on a stock split. When a stock split happens the numbers of shares outstanding are multiplied. In a two to one stock split an investor’s shares will double; with a three to one stock shift the amount of shares would triple.

How can a company afford to provide its investors with the extra shares? Simple, each share is worth less. Example: If you own a 1,000 shares of a widget company and each share is worth $10 after a two to one stock split you would own 2,000 shares each of which would be worth $5 each.  The net worth of your stock would remain the same.

The decision to initiate a stock split is made by a company’s board of directors and is welcome by stock holders. The decision doesn’t cost the company any money because the market capitalization is unaffected however a stock split makes investing in the company seem more appealing and attracts new investors. The stock price is lowered making it more affordable to the less affluent investor and keeps it in line with similar companies that potential investors might consider as alternative investments. There is also the illusion that because the price was recently higher it is destined to go back up to its former price.

Although there is no guarantee that a stock which has recently split will return to its pre-split price, the entrance of more investors often causes the stock to rise by increasing its demand. The increase in price encourages more investors. Another reason a stock split will increase money coming into the company and increase the newer split price is how the stock market views a company whose stock splits.

Generally the stock market looks favorable on companies that do a stock split because it is a reminder of how well they have done and there is the assumption that the company would not be engaged in a split if it was not fairly confident of continuing to well. Basically a stock split is both a reminder of the company’s good past performance and its confidence that it will continue to do well.

One might wonder why stock splits don’t occur more often.  If they increase demand by making the shares more affordable and make the company, look good why aren’t all stocks really cheap? The answer is that no company wants to be in the position of issuing a stock split and then due to a law suit, strike or other business mishap have their stocks fall to the point where the have to do a reverse split. In addition, although a stock split usually makes the stock go up, too much volatility can make investors nervous and they may sell decreasing demand and lowering the price.

A reverse stock split is where a company, in order to increase it share price to look better or even be delisted, divides the number of shares per investor and multiplies the price. Any company that has to do a reverse split as a result of a poorly timed stock split will lose all credibility in the market.

Because a stock split causes volatility, some companies choose to forgo splitting their stock no matter how high their stock goes. The Washington Post and Berkshire Hathaway are two examples of companies who have allowed their shares to rise in prices without splitting. Berkshire Hathaway has traded as high as $150,000 per share.

An important fact to remember when deciding if you want to buy stock that has recently split is that the stock will only pay a fraction, depending on how the stock split, of the dividend or earnings that a share earned previously.