Forward stock splits attract a lot of investor attention, so many companies use forward splits to develop more investor following for their stocks. Some companies regularly split their stock. They have large numbers of investors who happily accumulate large holdings of the stock this way. They also have loyal investors who regularly trade the stock splits for the extra profits they often provide. Although the intrinsic value of the stock is not changed by a forward split, investor excitement often drives the stock price up after the split is announced, and sometimes the stock rises further in post-split trading.
If you own 100 shares of a stock that splits 2-for-1, you still have the same percentage ownership in the company. That is because a forward split multiplies all the shares of the company by the same factor, so ownership percentages remain the same. The stock price is adjusted by the exchange when the split takes place. For example, if a stock is trading at $40 a share before the 2-for-1 split, it will be adjusted to $20 a share after the split. Even though the intrinsic value of the stock has not changed, many investors buy after the split because they feel they are getting a lower price, and this tends to drive the price of the post-split stock higher.
Certain companies get a reputation for splitting their stock when it reaches a certain price level. One reason given for the forward stock split strategy is that it keeps the price of the stock low enough to attract the average retail investor who may not be able to buy a round-lot of the higher priced shares. A round-lot is 100 shares of stock. Anything less than 100 shares is called an odd-lot and may carry an additional transaction cost above the basic commission, called an odd-lot fee, so some investors take advantage of being able to buy a round-lot when the stock splits. Whether this additional fee is charged depends on the policies of the brokerage firm, but online brokers often do not charge extra for odd-lot transactions.
Although stock splits have no affect on the intrinsic value of the stock, being basically cosmetic, many studies show that stock splits result in high performance. In two separate studies in1996 and in 2003, David Ikenberry, Chairman of the Finance Department at the University of Illinois at Urbana-Champaign, found price performance of split stocks outperformed the market by 8 percent during the year following the split and by 12 percent over the ensuing three years. He looked at over 1,000 stocks for each study, including 2-for-1, 3-for-1 and 4-for-1 stock splits.
The type of company that regularly splits its stock is usually a top-performer in terms of earnings growth. Even though the euphoria surrounding a stock split can add a few points to the price, if the company was not a top-performer, there would be no reason to split the stock to keep its price low enough for the retail investor. The stock would never have traded to a high price level without excellent earnings growth and future prospects.
Victoria Duff specializes in entrepreneurial subjects, drawing on her experience as an acclaimed start-up facilitator, venture catalyst and investor relations manager. Since 1995 she has written many articles for e-zines and was a regular columnist for "Digital Coast Reporter" and "Developments Magazine." She holds a Bachelor of Arts in public administration from the University of California at Berkeley.