Stock Splits
One of the alluring myths that surrounds
the stock market is the prospect that a certain stock may split, giving
stock holders twice as many shares as before. What is poorly understood
by the outsider, though, is that although the investor has more stock
after a split, the value of each share is reduced. For example, if a
corporation decides to split its stock 2-for-1, it issues one new share
for each outstanding one. At the same time, the value of each share
is cut in half. So the stock holders now hold twice as many shares but
the total value is the same as before the split. A stock split is like
receiving 2 five-dollar bills for a single ten-dollar bill. Same value
– twice as much paper.
Why would a company do this?
A lot of it has to do with investor psychology.
The price-per-share of a stock may be so high that the average investor
feels it is out of his reach. A stock split reduces the price so that
it may be more affordable to smaller investors. In reality, the small
investor could have bought a smaller number of pre-split shares for
the same price, but the appeal of buying a $20 stock as opposed to a
$60 may be strong for some investors.
Stocks can be split by a number of ratios but the
most common are 2-for-1, 3-for-2, and 3-for-1. Stocks can also be reverse-split
– the company reduces the number of outstanding shares so that
each stock holder has fewer shares than before. Reverse stock splits
are less common, but can be used for several reasons: the price per
share may be so low that it appears as a poor investment; the company
may be attempting to stave off possible de-listment on the stock exchange;
to push out minority stockholders; or as a way to go private.
Advantages
Lower prices per share can result in greater liquidity
– stocks are easier to sell at lower prices and there is less
of a bid/ask spread. This is especially true for stocks that are priced
in the hundreds of dollars – small investors view them as out
of their budget and the high bid/ask spreads (the difference between
buying and selling prices) can put off bigger investors.
Other advantages have to do with investor psychology.
A split is usually seen as a bullish indicator – stock prices
are increasing and the company is doing well financially. There is usually
a short-term rally around a stock which splits, but the market tends
to normalize after a short period.
On the downside, a split may cause investors to
expect more about how the company performs. If these expectations are
not met investor confidence may be shaken and the result could be a
drop in share prices.
The bottom line is a stock split does nothing to
affect the worth or performance of a company. It may be nice to own
more shares, but in the end your 2 five-dollar bills are still worth
the same as your ten-dollar bill.
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