Stock splits are relatively frequent events, with the stocks of most successful public corporations splitting at some point. As an investor, it is important to understand how a stock split works and how the split of a stock in your portfolio will affect its price.
A stock split occurs when one unit of stock is replaced by multiple units of a newer version. If, for example, you had 1,000 shares before the split and the board of directors of the issuing corporation decides to split the stock 3-for-1, your old shares will be removed from circulation and replaced by 3,000 new shares. The number of new shares you will get for each of your old shares is referred to as the split ratio. In this example, the split ratio is 3. The ratio can be expressed a single number, such as 3, or as a comparative figure such as 3-for-1.
Stock splits have no effect on the balance sheet of a corporation, and they do not make a difference in the net worth of the stockholder. A stock split merely cuts the same pie into smaller slices. Whereas the total shareholder equity of, say $120 million, was previously represented by 1 million shares, after the split, the same equity will be spread over 3 million shares. Only a footnote in the balance sheet, detailing how many outstanding shares the corporation has, will change. Since the price of each individual stock will also decline after a stock split, the total value of shares held by any particular investor will also remain unchanged.
Impact on Stock Price
After the stock splits, its price falls commensurately with the split ratio. In a 2-for-1 split, the share price usually drops by 50 percent. This is because each stock now represents a smaller ownership stake in the corporation — a smaller slice of a pie, the total size of which remains unchanged. To estimate where the stock price will be following a split, divide the pre-split price by the split ratio. If the stock was trading at $21 before the split and the split ratio is 3-for-1, the post-split price should be $7 — $21 divided by 3. Therefore, the market value of your stock holdings should also remain unchanged as a result of a stock split.
Corporations split their stocks to reduce the price of each individual share, therefore making the purchase of stock more affordable for the small investor. With the advent of electronic trading and the ability to buy a single share, stock splits are arguably less critical today than they were in decades past. While many traditional brokerage firms required the investor to buy at least a full lot, meaning 100 shares, today you can purchase even a single share of many stocks. Nevertheless, corporations tend to split their stocks if the price of each share climbs to astronomical levels, primarily due to the psychological effect that an excessively expensive unit price may have on individual investors.
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