If you deal in the stock market or plan to then you need to understand what stock splits are all about. Here we look at what a stock split is and the significance it has to any investor whether he/she be a newbie or a seasoned investor.
The Definition of a Stock Split
A stock split can be defined as “corporate action that increases the number of the corporation’s outstanding shares by dividing each share.” What this serves to do is to reduce the price. But what remains the same is the market capitalization of the stock. For example, if you went to the bank and had two $50 bills in your possession and wanted to exchange them for a $100 bill the value of what you have remains unchanged.
Let us look at an example of this in the investor’s world. A 2-for-1 stock split means that each stockholder receives an extra share for every share that he has. However the value inherent in each share has now been decreased by half. Think of it this way, the two shares are now equal to the value that the one share was to begin with before the split took place. This sounds a little confusing but it will become second nature to you once you have a better understanding of stock splits and how they work. Keep reading.
A concrete example of a stock split would help to demonstrate the point even better. Stock A is trading at $50. There are 10 millions shares of it to be issued. This means that the market capitalization is $500 million. The math is relatively simple in this case. It is $50 x 10 million shares= $500 million. It is then decided that a 2-for-1 stock split will take place. What this means for shareholders is that for every share they own at the present time they will receive one share. This share will be deposited directly into the brokerage account they hold. This means that now the one share they held has given way to two shares. However what has changed is the price. The stock has been split by 50 percent. It was $50 but now it is $25.
It is worth noting though that the market capitalization has remained the same. What has happened is that it has doubled the amount of the stocks that are outstanding to 25 million while at the same time reducing the price of the stock by half to $25. The capitalization has remained at $500 million. In other words, the value attached to the company has not been modified at all, rather just the mechanics with which the stocks are allocated.
There are different types of stock splits. The most common one is the 2-for-1 stock split, followed by the 3-for-2 split and the 3-for-1 split. If you are looking for the simplest way possible to calculate the new stock price then do this- take the previous stock price and divide it by the split ratio. In the example described above of a 2-for-1 stock split $50 was divided by 2 to leave us with $25 which is the new trading price. Is this starting to make more sense now? The same formula can be applied when you do a 3-for-2 split or a 3-for-1 split.
There is also something known as a reverse stock split. This is a 1-for-10 split. What this means is that for every 10 shares you own you will get one additional share. For example if you have 10 million shares pre-split then you will have $1 million post-split. The share price for the $10 million is $1 and for the $1 million is $10. In the end the market capitalization for the pre and the post-split remains at $10 million.
The Purpose of Stock Splits
You may scratch your head in bewilderment as you wonder what the purpose behind stock splitting really is. If the market cap does not get altered in any manner then why would a company decide to split the stocks it owns? There is more than one reason for this.
The first reason is psychological in nature. There are some investors that may feel that a stock is overpriced. Other investors who are new or very conservative may feel that it is not cost effective for them to purchase it. When a stock is split this lowers the share price to a more comfortable and accommodating place, thereby attracting the attention of a larger number of investors. The stock’s value has not changed but the reduced price will cause it to be viewed in a more positive light by investors. It also gives the shareholders who already own stocks in the company the feeling that they now have more shares than they did in the past. This instills more confidence in them.
From a more rational point of view, when a stock is split this increases its liquidity. By so doing the stock’s quantity of outstanding shares goes up. A basic principle of stocks is the higher their monetary value becomes per share the end result can be large bid/ask spreads. When shares are split, a lower bid/ask spread occurs as a result. This then makes the stock more liquid in the market.
The concept of stock splits does not fit in with financial theory at all. Many financial experts and professors of finance would tell you that stocks splits have no real benefit at all and indeed are completely irrelevant. This does not change the fact that many companies choose to do them. This interesting fact has opened up a new field of financial study that has been given the name, behavioral finance.
Not everyone sees stock splits in the same way. Some see them as a good thing for investors while others take a more pessimistic view. On one hand a stock split conveys the message that the prices of shares in a given company are going up and that means that the company is doing well. However the fact that the value of the stock stays the same also means that realistically speaking it really does not hold any advantages to those looking to invest.
Understanding stock splits takes some time. What you need to walk away with is the knowledge that while stock splits may have their place in the world of investing, doing this does not modify the value of a stock. The fundamentals of the stock remain in place. Do not let a stock split be what makes up your mind in terms of whether you should buy shares in a company or not.