Understanding Stock Splits
When a company splits its stock, the number of outstanding shares increases while the value of each share decreases in equal proportion. In most stock splits, one share of stock becomes two and the value of each share is halved, leaving the company's overall value unchanged. In some instances, a company executes a reverse split, in which the number of shares is decreased and the value of each share is increased.
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Common Splits
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The most common stock splits are 2-for-1, 3-for-2 and 3-for-1. If a company has a 2-for-1 stock split, one share valued at $200 would become two shares valued at $100 each. If the company chose a 3-for-1 split of that same stock, each share would be worth $66.67 each.
Why Do This?
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One of the primary goals of a stock split is to make shares more attractive to individual investors and stimulate buying. A company can split stock to increase liquidity. When a company's shares soar in value, there can be large disparities between the bids for the stock and its asking price. Splitting the stock closes that gap and can increase the number of potential investors.
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Advantages and Disadvantages
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There is division among market experts on the merits of a stock split. There is a belief that the impact of a stock split is purely psychological, as it tends to create the perception that the stock is more valuable. That may be enough to spur new buying. Some newsletters focus exclusively on stocks that have or could split. Critics say a split doesn't always result in new sales and is superfluous because the capitalization of the company is not affected.
Brokerage Commissions
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Stock splits no longer affect brokerage commissions because most brokerages now charge flat fees on trades, no matter how many shares are involved. Historically, brokerages charged commissions based on the number of shares traded, so a stock split helped boost their profits.
Reverse Split
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In a reverse split, a company combines a number of shares to create one share. Companies whose share prices are sliding can do a reverse split to avoid being dropped from a stock exchange or to prevent its stock from becoming classified as a penny stock.
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