Have you ever received a stock split and asked yourself: “What’s the point?” The justifications are, at best, debatable. Stock represents the ownership share of a corporation. Stock, along with retained earnings, is classified as stockholder's equity on a balance sheet. Equity can be visualized as the value of a company’s assets minus its liabilities. Companies typically issue millions of shares of stock and occasionally declare stock splits. Splits do not change the total value of stock, only the number of shares.
Anatomy of a Stock Split
A board of directors announces a stock split in the form of an “X-for-Y” exchange. For instance, in a 2-for-1 split, each of your shares with a market value of, for example, $80 is replaced by 2 shares worth $40 each. Your position value remains unchanged. Dividends, if any, are also split so that the dividend yield -- the dividend amount divided by the current stock price -- is undisturbed. The earnings per share is halved in this example, but the price-per-share divided by the earnings-per-share -- the P/E ratio -- remains the same. Stock dividends are similar to stock splits in that both result in the distribution of additional shares. However, stock dividends are paid for with retained earnings, whereas stock splits do not affect any account balances. The accountant simply makes note of the split and adjusts the nominal, or par, value of the shares accordingly.
Benefit One: Price
Some investors are intimidated by high-priced stocks, especially those priced over $100 per share. These investors would rather buy 100 shares at $50 each than 50 shares each priced at $100, even though there is no economic difference between the two. Even the commissions are the same. Companies are aware of this preference for lower prices and offer stock splits to make their stock prices “friendlier” to the small investor. Split stocks supposedly benefit from increased “liquidity,” the ability to sell stock without affecting its price. There is little evidence to support this conjecture.
Benefit Two: Signaling
While economists may view stock splits as a neutral occurrence, some advisers tout them as a bullish signal and encourage investors to buy stocks that are about to split. There is some evidence that stock prices do temporarily increase right after a split, but the same studies show that the effect disappears quickly. Nonetheless, corporations may use stock splits to signal that their businesses are doing well. Once again, this benefit is more psychological than financial.
Benefit Three: It’s Not a Reverse Split
While stock splits are probably neutral, reverse splits, where many old shares are consolidated into fewer new shares, is undoubtedly negative. It signals that a stock price has fallen to an “unrespectable” level, somewhere south of $10 a share. A reverse split calls attention to a stock price decline and raises a lot of questions as to why the price is so low. Below $5 per share, a stock is at risk of being delisted from the stock exchange, which would severely handicap the company’s ability to raise new equity funding.
Benefit Four: The Long Run
One of the most rewarding investments a person can make is to own shares that have a repeated pattern of growing and splitting. Take, for example, a stock with a history of climbing — following a split — to around $64 from $32 roughly every 24 months. A person who starts with 1,000 shares at $32 and who rides out the two-year cycle ends up with 2,000 shares representing the same total value as before the split. If the person rides out that cycle over a period of 20 years, she will have amassed 512,000 shares, and if she waits one more cycle and sells her shares just before the split — at say $63— her wealth will have climbed from $32,000 to more than $32 million. True, she would have earned the same return without the splits, except that the stock would have become so expensive that it would become hard to sell, a problem called "illiquidity."
- Return Performance Surrounding Reverse Stock Splits: Can Investors Profit?: An Article From: Financial Management; Seoyoung Kim et al
- The Little Book of Big Profits from Small Stocks + Website: Why You'll Never Buy a Stock Over $10 Again; Hilary Kramer, Louis Navellier
- Stock Market Rules: The 50 Most Widely Held Investment Axioms Explained, Examined, and Exposed, Fourth Edition; Michael D. Sheimo
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.