What Makes a Stock Split?

A stock split allows a company to increase the number of shares available for trading and cut the per-share price without diluting or reducing the value of current shareholder stake in the company. A company's stock splits only if the company wants it to. That decision typically comes from the board of directors, though some companies may put it to a shareholder vote.

How a Split Works

In a typical stock split, the company issues new shares to stockholders in direct proportion to the number of shares they already own. In a 2-for-1 split, stockholders will get one new share for every share they already own. So someone who owned one share will end up with two shares, someone who owned 500 shares will end up 1,000 and so on. A company can split its shares in any ratio -- 2-for-1, 3-for-1, 3-for-2, 10-for-1, etc. In 2010, holding company Berkshire Hathaway split its Class B shares 50-for-1. Since everyone's shares split, each shareholder ends up owning the same percentage of the company as before; that percentage is just spread over more shares. As a result, the per-share price of the stock falls according to the ratio of the split. A 2-for-1 split will cut the price in half, while a 3-for-1 split will cut it by two-thirds.

Price Psychology

Investors have been trained to see a constantly rising stock price as a good thing but it can create problems. Psychology plays an enormous role in the stock market. An investor who's eager to buy a stock at $50 a share might be more hesitant when the price reaches $100. Regardless of the company's fundamental financial condition, that high of a price can lead investors to speculate about whether the stock is overvalued. By splitting the stock, the company can bring the share price down to a level where more investors feel comfortable buying.

Increasing Liquidity

Companies also split their stock to boost liquidity, or the ease with which their shares can trade. Investors are more likely to buy a stock when they believe there will be an active market for it when it comes time to sell. A lower price makes a sale easier because it increases the pool of people with sufficient resources to buy. Also, many investors buy stock only in "round lots" of 100 shares. Reducing the share price through a stock split makes a round lot of a company's shares more affordable to more investors. Price-cutting has its limits, of course. Just as psychology can keep investors from buying a stock that's "too expensive," it can also steer them away from a stock that's "too cheap." Companies and market analysts are forever trying to identify the price that maximizes shareholder interest.

Good Publicity

Stock splits are also designed to send a not-so-subtle message to the market: "Our company is doing so well that investors have bid up the stock beyond the reach of many investors. So, we're going to split the stock to make shares more attainable for everyone." Shareholders and market-watchers get excited because they now have twice as many shares to watch increase in value, even though the value of the individual shares declined because of the split. That can produce a public relations windfall that boosts the company further.

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About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.

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