What Is the Definition of a Stock Split?
A stock split is nothing more than a shifting of numbers that ultimately does not change the value of a company or an investment position in its shares. The popular conception of a stock split is that it's a good thing for investors. Often stocks split after a significant appreciation in the share price, so this is probably the root of the positive association. But in reality, a split does not automatically create additional wealth for investors.
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Features
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Would you rather have 50 shares at $20 or 100 at $10? A stock split simply exchanges one scenario for the other, leaving the overall value the same. For example, if a company has a million outstanding shares selling at $20 per share and it effectuates a two-for-one split, the result is two million shares trading at $10 each. The positions of existing shareholders are modified to reflect the change, but do not change in value or percent of ownership.
Function
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Stock splits are designed to change either the share price of a company or the number of shares outstanding without diluting the total value of the shares, called market capitalization. A stock split might be useful in bringing a company's share price more in line with other stocks in the same sector, or to make the stock appear more affordable to retail investors. For purely psychological reasons, smaller investors tend to shy away from buying expensive shares with triple digit prices and may be more inclined to buy the same company at a lower price, though it is actually no cheaper.
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Types
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Though two-for-one is a very common split, any ratio is theoretically possible, depending on the needs and goals of the company. Three-for-two or seven-for-five are not unheard of. Reverse splits can also occur when a company needs to lift its share price to meet the listing requirements of the major exchanges. If it cannot do this by conventional business means, the last resort is to reduce its number of shares through a reverse split. In all cases, stock splits will not change the value of the company's market capitalization, but in the case of exotic ratios, fractional shares may be created. The company usually elects to retain fractional shares and compensates the shareholder with the equivalent cash value.
Effects
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Stock splits tend to make retail investors feel like they've received a net gain, since they own a larger number of shares than before the split. In reality, their ownership stake has not changed. Instead, they may only inherit heavier trading volume in the name at the more attractive share price, which may or may not affect volatility and liquidity. Some companies, like Berkshire Hathaway and Google, specifically choose not to split their stock, nurturing their image as elite companies through an exceedingly high per share stock price.
Considerations
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Stock splits also impact the options chains of a company. As with stocks, a split doesn't change the value of existing options but will alter the number of contracts in a position and the strike price, the level at which an option can be exercised. Options traders should be careful about how these changes to their positions change their exposure to volatility. The Options Clearing Corporation monitors stock splits to maintain a smooth, functioning market, but even so, options trading is a high-risk venture that should always be conducted with caution.
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