The term stock split may sound like trouble, but in reality, it's a common event that shouldn't intimidate savvy investors. In fact, being part of a stock split can have some advantages.
How Do Stock Splits Work?
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.
All stock splits are not created equally. More specifically, stock splits can vary depending upon what type of impact a firm wants to have on its underlying share price. For example, if a firm wants to cut its share price in half, then it will complete a 2-for-1 stock split. If it wants to lower its share price even further, then it may complete a 3-for-1 stock split. 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 determines exactly how many shares of stock the firm hands over to its existing shareholders.
After a stock split, the share price will simultaneously increase or decrease by the inverse of this distribution ratio. For example, in a 2-for-1 split (the most common type), the underlying firm doubles its total number of shares outstanding, but its stock price is subsequently halved. The end result to current shareholders is that they now hold twice as many shares of stock, but the stock's price is half of what it was previously. Therefore, the total dollar value of their holdings remains unchanged.
Here is a hypothetical example of what takes place in a regular 2-for-1 stock split:
Let's assume Company XYZ, 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* $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).
Less common is the 'reverse stock split,' which as the name implies, will have precisely the opposite effect. A firm completes a reverse split by reducing its number of shares outstanding. This forces the company's underlying stock price higher.
If the net effect to current shareholders is zero, then why do companies split their stock? Typically, it's to reduce the stock's share price. After all, high prices can act as a deterrent to prospective buyers -- particularly smaller ones. A stock split reduces a company's share price to a level that is hopefully seen as more affordable. Although, the reduced price tag may appear more attractive, a stock's price by itself -- without any other contextual comparisons -- is a poor gauge of value. 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. In the end, share prices are actually pretty meaningless, as they can be easily manipulated up or down by stock splits or reverse splits.
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 delisted 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.
How Can You Benefit from Stock Splits?
Novice investors often scour the market in search of impending stock splits, which they mistakenly consider a wealth-creating transaction. (After all, the split will grant them more shares.) However, it's important to remember that stock splits in and of themselves have zero impact on a firm's actual value.
Of course, that doesn't mean stock splits are completely useless either. After all, it's important for a firm to keep its share price in an optimal range to make it affordable for as many investors as possible. (The larger a firm's potential investor base, the greater value it is likely to attain in the market.) In addition, stock splits are often a positive signal from management because firms only tend to split their shares when they believe their fundamental corporate prospects are strong. As a result, studies have shown that stocks tend to outperform the market immediately after a split.
Ultimately, stock splits are merely a tool used by management to maintain some semblance of control over share prices. By themselves, though, they are essentially a nonevent, such as trading four quarters for a dollar or 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.