A corporation uses stock splits as a tool to control the share price range of its stock. Although a stock split does not affect the value of an investment in a particular stock, the split does affect some of the metrics you might use to judge the value of the shares. The earnings per share (EPS) amount will be directly affected by a split.
A stock split results in a lower EPS since the number of outstanding shares increases while the company's profit remains unchanged.
Effects of Stock Split
A stock split is declared with a ratio of new shares for the currently outstanding shares. As examples, with a 2-for-1 stock split, investors will receive two shares for each share owned before the split. A 3-for-1 split would result in investors holding three times as many shares.
When the split occurs, the share price declines by the ratio of the split, and the total number of company shares is increased by the ratio. If a company with 1 million shares and a $90 stock price declares a 3-for-1 split, after the split there will be 3 million shares outstanding worth $30 each.
How EPS Changes
Earnings per share refers to the net earnings – profits – earned by a company divided by the number of shares outstanding. A stock split increases the number of shares, and the amount of profit earned does not change, so a split will result in a lower earnings per share amount.
A 2-for-1 stock split will result in an EPS of half the amount of the pre-split earnings or what the earnings would have been had the split not occurred. The stock split effect on EPS is the increase in number of company shares due to the split declaration.
The Price-to-Earnings Ratio
The price-to-earnings (P/E) ratio metric will not be affected by a stock split. The split results in both a reduction of the share price and a reduction of the company earnings by the declared split ratio. The P and the E of P/E ratio decline by the same amount, leaving the ratio at the same level after the stock split. The P/E ratio provides a relative value of profitability to share price, allowing investors to use the ratio despite corporate actions like share splits.
Recognizing Splits in EPS Reports
When you research the earnings history of a stock, a stock split may be indicated by a sudden drop in earnings per share from one reporting period to the next. If you were aware of the recent stock split, you will see the effect on earnings. If you are unsure of whether a split caused the EPS decline, you can find the number of shares outstanding in the company's income statement. Look for a large increase in the number of shares.
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