A stock split is a corporate equity transaction that increases the number of shares outstanding while proportionally reducing the value per share. Companies can announce a stock split at any time. Stock splits aren’t unique to the United States; they happen in stock markets around the world. Wherever and whenever they happen, stock splits have no effect on existing shareholders’ equity, dividends or the underlying economics of the company. But a split may benefit existing shareholders and the company.
When Stocks Split
If a company announces a 2-for-1 stock split, for example, it will double the number of shares outstanding. If a company had 1 million shares outstanding and announces a 2-for-1 split, it will issue 1 million new shares to its stockholders. After the split, the company will have 2 million shares outstanding, and each stockholder will have twice as many shares as he had before the split. Doubling the number of shares immediately cuts the value of each share in half. A stock worth $10 a share before the split will be worth $5 a share after the split. Companies may also choose odd-number splits, such as 3-for-2 or 5-for-4. Such splits will have similarly proportionate effects on an individual stock's value.
Why Equity Is Unaffected
A stock split doesn’t affect the equity of existing shareholders because an investor who had 100 shares before a 2-for-1 split will have 200 shares after the split. If the stock was worth $10 a share before the split, the investor had $1,000 worth of stock. After the split, the stock is worth $5 a share, but the investor has 200 shares so he still has $1,000 worth of stock. The investor’s share holding doubled in size without him having to put out any more money, while the overall value of his holding stayed the same.
No Dividend Loss
If the company pays a dividend and splits 2-for-1, the dividend per share is cut in half but is paid on twice the number of shares. If the stock was paying a dividend of $4 per share per year before the 2-for-1 split, it will pay $2 per share after the split. An investor who owned 100 shares before the split collected a $4 per share dividend for a total of $400 per year. After the split, he collects a $2 dividend per share, but because he now owns 200 shares he still receives $400.
Stock splits don’t affect proportional ownership. If a company makes a 2-for-1 split to double the number of total shares, it doubles the number of shares owned by each of its existing stockholders. Before the split, a shareholder who owned 10,000 of the company’s 1 million shares owned 1 percent of the stock. After the split, he owns 20,000 of the company’s 2 million shares, so he still owns 1 percent of the stock.
Benefit of Splits
Companies split their stock to make it look more affordable to smaller investors, thereby broadening their investor base. If a company’s share price climbs into the hundreds or thousands of dollars per share, the stratospheric price may deter investors who don’t see much more upside potential or who simply can’t afford the price. The reduced stock price, because of the split, may make the stock look more attractive despite the larger pool of shares. If the more-affordable price excites investor interest, they’ll drive up the market price per share, enriching those who already own the stock. Many investors view a stock split as a positive signal by management that the company’s future prospects look good and bid up the shares accordingly.
Herb Kirchhoff has more than three decades of hands-on experience as an avid garden hobbyist and home handyman. Since retiring from the news business in 2008, Kirchhoff takes care of a 12-acre rural Michigan lakefront property and applies his experience to his vegetable and flower gardens and home repair and renovation projects.