I bet that you have heard something called a stock split. During the bull (up) market of the 1990s many U.S. listed companies split their stock. What is a stock split and why do they happen?
When the price of a stock has gone higher for a long time many companies, often at the suggestion of their investment bankers, split their stock’s price. Corporations have the option of splitting the stock to lower the price, creating a market environment that stimulates trading. When a stock is split, there are more shares available but the total market value remains the same. Say a company’s stock is trading at $50 a share. If the company declares a two-for-one split, it gives every shareholder two share for each one held. At the same time the price drops to $25 a share. An investor who owned 300 shares at $50 now has 600 at $25—but the value is still $15,000. Stocks can be split three for one, three for two, 10 for one or any other combination.
The initial effect of a stock split is no different from getting change for a dollar. But there are more shares available, at a more accessible price. Stock splits often entice investors to buy a company’s stock when the company announces a split.
There is also something called a reverse split. In a reverse split you exchange more stocks for fewer—say 10 for five—and the price increases accordingly. Reverse splits are sometimes used to raise a stock’s price. This discourages small investors who are costly to keep track of and may attract institutional investors who may refuse to buy stock which costs less than their minimum requirement—often $5 a share. Reverse splits also reduce the outstanding capitalization (amount of shares) on the market, which can help earnings-per-share if the company can increase its net profits.
Just because a stock is going to split is no reason to buy the stock. Historically, many stock splits over a short period of time, is a sign of an important high in a stock’s price. Additionally, if a very large number of companies split their stock it is often a sign of a market top.
In short, a stock split increases the number of shares outstanding and makes the price more attractive to potential investors, but it changes neither the quality nor the value of an investment. Earnings, dividends and book value figures all are split along with the price, and the fundamental value of the holding is unchanged. If a company was undervalued before a split, it will be undervalued after the split.
However, if a split occurs when the price is overvalued (which often happens), it can trigger a decline. Investors are more apt to sell split shares to establish capital gain when the price is overvalued and there is a profit to protect.
Quote of the Week: “Money makes money. And the money that money makes more money.”—Benjamin Franklin
Bart Ward is the chief executive officer of Ward & Co. Ltd. an Anoka based registered investment advisor – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.