Every so often a company announces a stock split. This means that the company increases the number of its outstanding shares held by its existing shareholders. Stock splits don't affect shareholder's equity. The best analogy of a stock split is taking a pie that is already cut into eight slices and cutting the pie even further into 16 slices.
All publicly-traded companies have a specific number of shares outstanding available to shareholders. A stock split occurs when the board of directors decides to increase the number of shares outstanding by issuing more shares to its existing shareholders. A 2-for-1 stock split means that for every one share held by a shareholder, he receives an additional share. Therefore, if the company had 25 million shares outstanding, the 2-for-1 stock split increases the shares outstanding to 50 million.
After the Stock Split
You would think that shareholder's equity increases with an increase of shares outstanding. However, it does not. This is because the stock price of the company declines to account for the split to maintain the same value of shareholder's equity before the split. For example, if the stock price was $20 per share before the 2-for-1 stock split, the price of the shares declines by exactly half. Before the stock split, the market capitalization of the company was $20 multiplied by $500 million. After the stock split, the market capitalization remains exactly the same because the new share price is $10 and $10 multiplied by 50 million shares is $500 million.
Why Do Stocks Splits
The primary reason why companies issue stock splits is to make the shares more affordable to small investors. This also has the potential to boost the company's share price after the stock split, as small investors begin to acquire the less expensive shares. A company may also initiate a stock split if its share price is high relative to similar companies in the sector.
Reverse Stock Splits
Another version of a stock split is a reverse stock split. A reverse stock split reduces the number of outstanding shares but shareholder's equity remains the same. A company may initiate a reverse stock split to boost its share price. For example, a 5-for-1 reverse stock split of 10 million shares, reduces the number of shares outstanding to 2 million and boosts the share price from $1 per share to $5 per share. In both cases, the company is still worth $10 million.
- Apple pie image by Ivonne Wierink from Fotolia.com