Stock splits can understandably be confusing to investors. Investors may worry that a stock split will adversely affect the value of their investment since their share prices automatically decrease as a result of the split. You really have nothing to fear. A stock split works much like getting change for your money at the bank. For example, if you exchange a $20 bill for two $10 bills, you still own the same amount of money even if the denominations are smaller.
Basic Share Price Splits
When a company decides to split their stock, they are making the decision to increase the number of shares owned by investors. For example, if you own 100 shares of IBM stock currently valued at $100 a share, and a two-for-one split occurs, you will own 200 shares of IBM stock priced at $50 a share after the split. While the price per share decreases, your ownership percentage stays exactly the same.
Companies can also increase the share price of their stock by performing a reverse stock split. Instead of increasing the number of shares it has outstanding, a reverse split decreases the number of existing stock shares. Using the IBM example above, if IBM chooses to perform a one-for-two split, your share price will be adjusted to $200 per share, but you will now own only 50 shares of IBM instead of 100.
Reasons For a Stock Split
Companies choose to split their stock prices for two basic reasons -- investor psychology and liquidity. If a company's share price is relatively high -- $200 a share, for example -- many investors may feel the stock is expensive and avoid buying. Meanwhile, liquidity can be an issue for investors in companies that have low average trading volume. If a company splits their shares, increasing the number of shares in the market, trading volume increases as well, making it easier for investors to quickly buy or sell shares.
When a company with a relatively high stock price splits its shares and decreases share prices, it often attracts new investors. Stock prices can rise as demand for company shares increase. Thus, attracting new buyers can subsequently increase value for investors. Improving a stock's liquidity can have the same effect. As a stock becomes more liquid, it can attract investors who previously avoided buying due to illiquidity.