The concept of a stock split may sound confusing, but the idea is simple. For the most part a stock split will not make or break a company. Nevertheless, it is important to grasp what happens during a split, because trading patterns on the stock could change as a result.
The number of outstanding shares of a corporation is under the discretion of the board of directors. The board can change the number of shares through various means, one of which is a stock split. When the board declares a stock split, each share is, quite literally, divided or split into multiple shares. A two for one split, often expressed as 2:1 in the financial media, means that each share is divided into two shares. There is no theoretical limit to how many parts each share can split into. There have been stock split ratios of as high as 10 to one. Following a split, shareholders submit their old shares and are given new, and naturally a larger quantity of, shares by the issuing firm. With today's computer based systems, this process takes mere seconds and is carried out by the brokerage on behalf of shareholders.
Effect on Shareholder Equity
Stock splits do not affect shareholder equity. The par value of each share will decrease by the same proportion as the split ratio. If the par value of each share was $10 before a two to one split, the new value of a unit share will be $5. With twice as many shares outstanding, the total par value of the entire firm, and also of an investor's shares will remain the same. Par value is the issuance value of each share and it is the value at which shares were initially sold to investors. The total shareholder equity on the firm's balance sheet is independent of number of shares outstanding or unit par value and will not change as a result of a stock split.
The market price of each share will decrease by the same proportion as the stock split. If each share was trading at $30 before a three to one split, the share will resume trading at $10 per piece following the split. This is because each share now represents a smaller ownership stake, or a smaller slice of the pie, so to say. What the owner of one share was entitled to before the split, in terms of voting rights and dividend payments, now the owner of three shares will be entitled to. Hence, price declines to one third of previous levels.
The main reason companies split their stocks is to make each share more affordable. A share split reduces the price of each individual share, thereby making a lot of 100 shares more affordable. This may increase trading activity, and thereby liquidity in the stock. Liquidity is a measure of how frequently a stock changes hands. The more liquid a stock, the more stable its daily price activity tends to be.
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