What is a Stock Split?

Stock Split

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Stock Split

A stock split is a corporate action in which a company divides its existing shares into multiple shares. Though the number of shares outstanding increases by a specific multiple, the total dollar value of the shares remains the same compared to pre-split amounts, which means that the shareholder’s equity doesn’t change. Essentially, it’s a method used by companies to increase the liquidity of their stock and make shares seem more accessible to retail investors, especially if the share price has become very high.

Here’s how it works:

  • Ratios: Stock splits come in ratios. For instance, in a 2-for-1 stock split, each shareholder receives an additional share for every share they own. So, if you had 100 shares before the split, you’d have 200 shares after it.
  • Stock Price Adjustment: Following the 2-for-1 split example, if the stock price was $100 per share before the split, it would ideally adjust to $50 per share after the split.
  • Market Capitalization Remains the Same: Before the split, with 1 million shares at $100 each, the market cap would be $100 million. After the split, with 2 million shares at $50 each, the market cap remains $100 million.
  • Dividends and Earnings: These also adjust accordingly. If a company paid $1 per share in dividends before the split, it would pay $0.50 per share after the 2-for-1 split.

Stock splits can also be reverse splits, where a company reduces the number of shares outstanding. For instance, in a 1-for-10 reverse split, for every 10 shares an investor owns, they would now own just 1 share. Companies might do this to avoid being delisted from stock exchanges that have minimum price requirements or to make their stock appear more valuable.

Why do companies do stock splits?

  • Perceived Affordability: If a stock’s price is very high, some retail investors might perceive it as expensive or out of reach. A stock split brings down the nominal price of shares, making them appear more affordable, even though the company’s underlying value hasn’t changed.
  • Increased Liquidity: Lower-priced shares often have better liquidity, meaning they can be bought and sold more easily.
  • Psychological Boost: A split might be interpreted by the market as a sign of confidence by the company in its future, suggesting that management believes the stock price will continue to rise.

It’s crucial to understand that stock splits don’t change the intrinsic value of an investor’s holding. If an investor owns 1% of a company before the split, they will still own 1% after the split.

Example of a Stock Split

Let’s use a hypothetical example to illustrate the concept of a stock split:

Company C:

  • Current Stock Price: $200
  • Current Number of Shares Outstanding: 1,000,000
  • Current Market Capitalization: $200 million ($200 x 1,000,000 shares)

Suppose Company C decides to conduct a 2-for-1 stock split.

Post-Split Details:

  • Shares Outstanding: Since it’s a 2-for-1 split, the number of shares doubles. So, the new number of shares outstanding becomes 2,000,000.
  • Adjusted Stock Price: The stock price is halved to reflect the split. So, the new stock price becomes $100.
  • Market Capitalization: The total market capitalization remains the same. It’s still $200 million (2,000,000 shares x $100/share).

For an individual shareholder:

If you owned 100 shares of Company C before the split, valued at $20,000 (100 shares x $200/share), after the split, you would own:

  • 200 shares (because of the 2-for-1 split)
  • But they would now be priced at $100 each
  • So, the total value of your holding remains $20,000 (200 shares x $100/share).

In essence, nothing has fundamentally changed about the company or the value of your holdings. The company has merely increased the number of its shares and adjusted its share price accordingly.

This example simplifies the mechanics of a stock split. In the real world, stock prices are determined by the open market, and there might be other factors at play that can cause the stock price to fluctuate after a split. However, at the moment of the split itself, the described adjustments are typical.

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