Stock split definition: what is a stock split?
A stock split is a corporate action that involves the division of each of a company's shares into multiple shares, increasing the total stock in the company. This revalues the price per share to ensure the market capitalisation of the company does not change.
For example, if a company's shares are valued at $50 and an investor owns 100 shares, the total worth of his investment will be $5,000. If the company then splits it stock by 2, the investor will now own 200 shares, but at a value of only $25 each, so his total investment will still be worth $5,000. This is an instance of a 2-for-1 stock split. Stocks can be split at a ratio of 3-for-1 if desired.
Imagine that stock A is trading at $50 and has 10 million shares issued, rendering the stock a market capitalization of $500 million (the share price multiplied by the amount of shares issued). The company decides to split the stock, with a 2-for-1 split. Now each shareholder receives an additional share for every share they hold. This means that they now have two shares for each share previously held. But the price of each share has been halved ($25 per share). Note, however, that the market capitalisation stays the same. This is because the true value of the company hasn’t changed at all. Simply the number of stocks has doubled.
Where have you heard about stock splits?
Rumours of stock splits can hit the headlines, as pundits ponder the value of big companies. Retail giant Walmart, for example, has repeatedly split its shares since going public in the 1970s.
What you need to know about stock splits.
Companies often split their stock to make it easier to trade, because the stock split will have increased the liquidity of the shares by making each individual unit less expensive. For example, if the share price has become too high for small traders to acquire stock, it makes sense to divide the shares so that new investors are able to start investing by buying smaller units. Existing investors are not affected: they simply end up with more stock at a lower value per share.
Stock splits can sometimes drive share prices up: because investors believe the split will cause an increase in share price, more investors buy the stock and the stock increases in value as a result.
Sometimes a company will carry out a reverse split: this is when the number of shares are reduced by a multiple, without changing the market value.
What is the purpose of a stock split?
There are various reasons why a company may undergo a stock split.
Firstly, a stock split can play to a psychological advantage. As the price of a security increases, getting higher and higher, some investors may feel that the price is too high for them to buy, in other words, it may seem unaffordable. Simply splitting the stock brings the price down to a psychologically more appealing level. The actual value of the share does not change, but the relatively lower stock price may affect the way the shares are perceived and attract new investors.