Learn The Stock Market Lesson – Stock Splits: Meaning and Purpose

A stock split is an action that companies might decide to do especially if their stock has been very successful. A stock split would increase the number of shares outstanding by dividing them into multiple shares to be traded publicly. However, this does not change the total market capitalization (the total market value).
[Total market capitalization is calculated by: # of shares outstanding X price per share].

For example, suppose company XYZ has a total of 20 million shares of stock outstanding at the price of $50 per share. If XYZ’s board of directors decided to do a two-for-one split and the shareholders approved it, they can increase the number of shares outstanding from 20 million to 40 million, which would then cause its price to decrease from $50 to $25 per share. In both cases, the market capitalization does not change as shown below:

1) Before- 20 million shares outstanding X $50 per share = 1000 million (market value)
2) After- 40 million shares outstanding X $25 per share = 1000 million (market value)

[Here Company XYZ has decided on a 2-for-1 split, meaning that each stockholder receives an additonal share for each share that he/she already holds.]

So, what’s the difference between the two scenarios? After the stock split, current shareholders have twice as many shares, and new investors can buy shares at a lower price. Stocks can be split in any number of ways: two-for-one (as shown in the example above), three-for-two, three-for-one, etc.

What are possible reasons why a company would decide this? One primarily reason is to stimulate trading and to enable smaller investors to buy shares since the shares would now cost at a lower price than initially. Since most investors buy shares in round lots (e.g. a block of 100 shares) because commissions are higher for odd lot transactions (e.g. block of anywhere from 1-99 shares), it can be difficult for smaller investors to buy shares of a company whose stock is priced at $200. However, if that company splits its shares five-to-one, the price would drop to $40 per share, making it easier for smaller investors to buy that company’s stock. Again, the market value of the company hasn’t changed, but the total number of outstanding shares has increased by a factor of five.

Many times, a stock’s price will rise somewhat after a split, perhaps because investors become more interested in the stock, causing a wave of buying. Also, generally, a stock split is perceived as a positive indicator for a stock and the company, because stocks that are doing poorly usually are priced low to begin with.

Next Lesson: Reverse split!

Tags: investing, odd lots, reverse split, round lots, shares outsanding, stock market, stock split, total market capitalization, trading

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