A stock split occurs when a company’s board of directors decides to increase the number of outstanding shares by issuing additional shares to current shareholders at no cost. That is, the exercise is not to raise fresh capital from investors, but simply to increase the number of shares available.
For example, stock splits can be done in any multiple or ratio although a simple 2-for-1 stock split is perhaps the most common. In this case, one additional share is given for each share held by a shareholder. If a company had 100 million shares outstanding before the split, it will have 200 million shares outstanding after the split Each individual shareholder will therefore see their position size double.
However, there is no free lunch. A doubling of the position size will trigger an equal offsetting reaction in the stock price. There is no economic reason why the market capitalization of the firm should change. Using the previous example, if the firm had a market cap of $500m, each share would be worth
$500m / 100m shares = $5 per share
Following a 2-for-1 split, the share price will be halved as
$500m / 200m shares = $2.50 per share
It is only the number of outstanding shares and the share price that change, the market capitalization remains constant. Dividends will also be adjusted by the stock split ratio. Naturally, the earnings per share will also change whereas the Price Earnings ratio will remain constant.
Reasons for a Stock Split
A stock split is usually done by companies for the following reasons
- their share price has increased to levels that are too high or beyond the levels of similar companies
- liquidity in the stock
- signals confidence to the market
The price reduction may make the shares seem more affordable to smaller investors even though the underlying market capitalization of the company does not change. This is purely psychological. However, the effect on the share price of small investors’ purchases of a large company is often negligible. Indeed, some companies have a completely opposite strategy. Berkshire Hathaway has refused to split its stock and keeps the stock price high. This, they claim reduces volatility in the stock. In the meantime, share price performance does not appear to have been negatively impacted.
When the management of a company initiates a stock split, it is potentially signaling to the market its confidence in the future prospects of the company. Investors often react to this news positively and assume the growth will continue, thus causing a rise in the post split stock price.
Stock Split Example
In June 2014, Apple (AAPL) split its stock in a ratio of 7-for-1. This made the stock more accessible to a larger number of investors. Immediately prior to the split, each Apple share was trading at $645.57. Post split, the price per share at market open was $92.70, which is more or less equal to the anticipated value of 645.57 / 7.
As per the description above, a shareholder holding 100 shares with a total value of $64,557 would subsequently own 600 additional shares for a total of 700 with a value of $64,890. The total share count increased from 861 million to 6 billion shares whilst the market capitalization remained broadly unchanged.
