A stock split, unfortunately, doesn't make a difference to an investor's equity.To understand why this is the case, let's review the mechanics of a stock split.
A stock split is a corporate action in which a company divides its existing shares into multiple shares.
Basically, companies choose to split their shares so they can lower the trading price of their stock to a range deemed comfortable by most investors and increase the liquidity of the shares. Human psychology being what it is, most investors are more comfortable purchasing, say, 100 shares of $10 stock as opposed to 10 shares of $100 stock.
Thus, when a company's share price has risen substantially, most public firms will end up declaring a stock split at some point to reduce the price to a more popular trading price.
Key Takeaways
- A company will sometimes announce a stock split when the price of the shares has risen to the point that it might be unappealing to investors who are more comfortable with lower-priced securities.
- A stock split increases the number of outstanding shares and therefore increases the liquidity of the shares.
- However, the total amount of the shares stays the same, since the split does not change the stock's valuation.
What Happens When a Stock Split Occurs
Although the number of shares outstanding increases during a stock split, the total dollar value of the shares remains the same compared to pre-split amounts, because the split does not add any real value.
When a stock split is implemented, the price of shares adjusts automatically in the markets. A company's board of directors makes the decision to split the stock into any number of ways.
A stock can be split a variety of ways, such as 2-for-1, 3-for-1, 5-for-1, 10-for-1, or 100-for-1.
Stock Split Example
Let's walk through a simplified example: supposeCory's Tequila Corporation(CTC) has one million shares outstanding at $80 per share and then initiatesa 2-for-1 split.
Next, consider two investors, Valerie and Marty, who each owned a stake of CTC before the split. Valerie owned 8% of the outstanding shares (or 80,000 shares) and Marty owned 2% (or 20,000 shares). When the split occurs, CTC instantly doubles the number of its outstanding shares to two million. In other words, every investor who owned shares prior to the split now owns twice as many as they did before. Of course, since every investor owns twice as many shares, everyone maintains the exact same percentage stake in the company. Keep in mind that when a stock undergoes a 2-for-1 split, its share price is roughly halved, so while there are 100% more shares, each is 50% lower in price.
For example, Valerie owned 80,000 shares before the split. Since there were 1,000,000 CTC shares outstanding at the time, her 80,000 shares represented an 8% stake in the company. Thus, every dollar of net income the firm earned essentially put eight cents into her pocket (though the company would probably not pay out its entire profit in dividends, but keep most of it as retained earnings for expansion).
After the split, Valerie owned 160,000 shares. However, there were also twice as many CTC shares available after the split, or 2,000,000. Thus, her 160,000 share stake is still exactly 8% of the company's equity (160,000 divided by 2,000,000), and she is still entitled to the same eight cents of every dollar of the firm's earnings. The same calculation can be performed for Marty. He had a 2% stake before the split, or 20,000 shares of 1,000,000. After the split, he has 40,000 shares of 2,000,000 –the same 2% stake.
Special Considerations
In simple terms, you can view a company as a pie, with each investor owning a slice. When a stock split occurs, you are basically taking each investor's slice and cutting it in half. Thus, the two new slices are the same amount of pie of the previous, larger slice.
Another way to view stock splits is to consider a dollar bill in your pocket –its value is obviously $1. Of course, if you were to "split" the dollar bill into 10 dimes, the value of the money in your pocket is still $1 –it's just in 10 pieces instead of one. Thus, when one of your stocks splits 2-1 (or even 10-1, for that matter), there is no increase in the value of your position or the earning power of your shares, since your percentage stake in the company remains exactly the same.
