A stock split is when a publicly owned company divides its shares of stock, creating more shares. A 2-for-1 stock split, for instance, means for every share of stock you owned before the split, you have two afterward. The result is the value of each share is cut in half. Making the share price more affordable for investors is a common objective of stock splits. Despite their intent, stock splits do have some disadvantages for companies and shareholders.
Mathoda Capital fund manager Ranjit Mathoda pointed out in a February 2011 article "What are the pros and cons of doing a stock split?" that lower price stocks are psychological easier for shareholders to sell. As share prices rise, investors perceive the value of each share as being great. They also tend to associate a high price with successful company management and growth. Once share prices drop after a split, more impulsive selling is common.
Over time, stock splits create record-keeping challenges for company accountants, analysts and shareholders. A typical historical chart shows how a share price rises and falls over time. When you split a stock, the chart would naturally reflect the quick drop in share price. This doesn't not offer a fair assessment of the value of company stock. Fortunately, advanced software tools make it easier for companies and investors to show split adjustments on charts. A split adjustment allows a reader to see the up-and-down price action in a stock without the spikes resulting from stock splits.
Low Price Risks
Normally, companies split stocks when things are going well and the share price is on the rise. However, an overly aggressive split may lead to risks if the share price falls too much going forward. A company whose share price grows from $5 per share to $20 in two years may decide to do a 2-for-1 split. This puts each share at $10. If the economy and company fall on hard times, the share price could drop below $5. This makes it less attractive to large buyers and mutual funds. If it falls farther, below $1, it could face delisting warnings from NASDAQ or the New York Stock Exchange.
For the company, splitting stock is not free. Stock splits result from either a board of directors meeting and decision, or a vote of shareholders. Either approach has costs. Also, the company must meet listing exchange and legal requirements by letting shareholders know of the date and effects of the stock split. Writing notification letters and mailing them out to all shareholders gets pricey for companies with a lot of owners.
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