A stock split happens when a publicly traded company increases the number of shares they have outstanding without changing their market capitalization, or combined value. How do they do that?

Simple — they just change the value of each share enough that all of the shares are now worth the same as the old number of shares used to be worth. For example, if a company has 10 shares of $2 stock out there, they’ve got a market capitalization of $20 (10 shares x $2 per share).

Now, let’s say they decide to do a “2 for 1” split…after the split takes place they’ll have 20 shares of $1 stock. Even though they’ve got twice as many shares out there, the market cap is still $20 (20 shares x $1 per share).

If you’re an investor in that company, the value of your investment also stays the same because now you have twice as many shares as you started with before the split.

Why Do Splits Happen?

So, what’s the benefit of having a stock split when the total value of the company stays the same? Well, there are a couple of schools of thought on this one…

First is market psychology. For lots of people — particularly newer investors — a stock with a lower share price is going to be a lot more palatable than one with a higher price.

Look at Microsoft — the software powerhouse is a staple in many a portfolio. As of this writing, it trades under $30 per share, but what if it never split? Today, you’d be looking at a stock that cost $8,389 per share, meaning that buying a single share in MSFT would take a considerable amount of money.

Another reason companies split is for increased liquidity. When companies split, they have more shares available to trade, so it becomes easier to find shares to buy and sell. Historically speaking, companies that split at highs usually continue to see good performance — at least in the short term.

Not all companies split, however. Some choose not to…

Super-investor Warren Buffet’s Berkshire Hathaway has never split; since 1990, the stock has shot up 1,494%, making each share of BRK. A worth $130,650.

Reverse Splits… Sounds Painful

Stocks often split when they’re getting expensive… Likewise, stocks with lower share prices sometimes decide to do reverse splits. A reverse split is exactly what it sounds like. Instead of increasing the number of shares they have out there, they decrease them.

The biggest reason companies do reverse splits is to make sure their share prices stay high enough to meet exchange restrictions and investor expectations.

Administrative concerns are one reason that some companies decide to have reverse splits. For a smaller company, keeping track of millions of shares can be a pretty big burden — and an unnecessary one if those shares are held by a smaller group of people. Reverse splits lower their administrative costs by lowering the number of shares they have out there.

Also, major exchanges like NYSE and NASDAQ require companies to trade at a minimum share price (usually at least $1) in order to stay listed on an exchange. If a company was close to the threshold, or was an over-the-counter company vying for a spot on NASDAQ for example, a reverse split might be in order to bring up their share price.

It’s No Split-Second Decision

An important thing to remember is that stock splits aren’t split decisions…if a company’s declaring a split, they’re doing it for a good reason. Stock splits are fairly common in the investment world — and they’re nothing to worry about now that you’ve got a grip on splits.

Cheers,

Jonas Elmerraji
April 1, 2008

What a Stock Split Means for Your Investments was originally featured in the Penny Sleuth.