The Effects of a Stock Split

The company I work for and invest a small amount in through the Employee Stock Purchase Plan has recently announced that they would be executing a 2-for-1 stock split. A stock split is simply the dividing of a company’s existing stock into multiple shares. A stock split is usually a good indicator that a company’s share price is doing well. However, a stock split doesn’t give you any more value, just twice as many shares.

For example, in a 2-for-1 split, each stockholder receives an additional share for each share he or she holds. The price of the shares are adjusted such that the before and after market capitalization of the company remains the same and dilution does not occur.

There is also a reverse stock split, which is just the same but in reverse: a reduction in number of shares and an accompanying increase in the share price.

Theoretically a stock split is a non-event. The fraction of the company that each share represents is reduced, but each stockholder is given enough shares so that his or her total fraction of the company owned remains the same.

Why then do companies perform stock splits?

The first reason is psychology. A stock split generally occurs in the face of new highs for the stock. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy. Splitting the stock brings the share price down to a more attractive level. The effect here is purely psychological.

The actual value of the stock doesn’t change one bit, but the lower stock price may affect the way the stock is perceived and therefore entice new investors. In practice, an ordinary split often drives the new price per share up, as more of the public is attracted by the lower price. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before, and of course, if the prices rises, they have more stock to trade.

Another reason, and arguably a more logical one, for splitting a stock is to increase a stock’s liquidity, which increases with the stock’s number of outstanding shares. You see, when stocks get into the hundreds of dollars per share, very large bid/ask spreads can result. A perfect example is Warren Buffett’s Berkshire Hathaway, which has never had a stock split. At times, Berkshire stock has traded at nearly $100,000 and its bid/ask spread can often be over $1,000. By splitting shares a lower bid/ask spread is often achieved, thereby increasing liquidity, and making it easier to trade. This is always good.

After a split, shareholders will need to recalculate their cost basis for the newly split shares. Recalculating the cost basis is usually trivial. The shareholder’s cost has not changed at all; it’s the same amount of money paid for the original block of shares, including commissions. The new cost per share is simply the total cost divided by the new share count.

The most important thing to know about stock splits is that there is no effect on the worth (as measured by market capitalization) of the company. A stock split should not be the deciding factor that entices you into buying a stock. While there are some psychological reasons why companies will split their stock, the split doesn’t change any of the business fundamentals. In the end, whether you have two $50 bills or one $100 bill, you have the same amount in the bank.