Purpose of Stock Split

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Stock market knowledge
Stock market knowledge (Image: Image by Flickr.com, courtesy of Duncan Rawlinson)

A stock split can be an important event for a company and its shareholders. Investors should understand what a stock split means for the shares of a company they own or are considering owning.

Function

A company's board of directors can decide to issue more shares to company shareholders by electing to declare a stock split. On the effective date of the split, shareholders will be issued new shares of stock in accordance with the stock split ratio.

Identification

Stock splits can be declared in any ratio. Typical ratios are 2 for 1, 3 for 2, 3 for 1 and 5 for 1. If the stock is being split 2-1, after the split shareholders will own twice as many of the company's shares.

Effects

When a stock split is declared, the total dollar value of the shares outstanding does not increase. When the stock split is effective, the stock price will fall to keep the market value of the company the same. If before a 3-1 stock split the stock value is $60, after the split it will trade for $20.

Considerations

For a investor owning a stock that splits, the value of her holdings in the stock will not change. If she own 100 shares of a $50 stock before a 2-1 split, after the split she will have 200 shares of a $25 stock.

Purpose

The purpose of a stock split is to lower the share price to a value that is attractive to investors. Many stock investors do not like to buy high priced stock, but will consider a stock after a split after the share price is lower.

Potential

Although a stock split does not change the total value of a company's outstanding stock, many investors see splits as a positive sign. According to an article in "Forbes," stocks that split outperformed the market by an average of 8 percent in the first year and 12 percent in the three years following the split.

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