Stock splits are probably the most misunderstood aspect in the stock market. Most investors think that a stock split involves getting twice or sometimes three times the amount of stocks that one previously owned. It is not surprising to see the value of a stock rise just before the date of a company stock split.
What is a Stock Split?
A stock split is a company action that increases the number of a company’s outstanding shares by dividing or splitting its current outstanding shares. There are two things to remember that happen in a stock split,
By dividing the shares, the price of the shares is reduced immediately after the stock split.
The company or stock’s market capitalization remains the same.
To understand a stock split, consider this common example: You have a 20-pound bill and someone offers you two 10-pound bills for it. As you can see, an exchange will not make a difference to the total value of what you had.
The most common stock splits are 2 for 1, 3 for 2 and 3 for 1. A company is trading at 40 pounds and has 10 million shares issued. The market capitalisation of the company is 40*10 = 400 million pounds. The company offers a 2 for 1 stock split. This would give one share for each share currently owned by the shareholder. The stock split would leave the new value of the company shares at 20 pounds per share.
Why Companies have Stock Splits
One of the reasons why companies have stock splits is wholly psychological. When the prices of stocks become too high, fewer investors are willing to buy them. A company will have a stock split to encourage new investors in their stock. For current owners, they have the feeling of owning more shares in the company.
Liquidity is also considered when deciding on stock splits. As a company stock value increases, fewer investors can afford it. This leads to a higher bid ask spread that reduces the number of its shares that are traded.
The interesting thing about stock splits is that they have no financial effect on the performance of a company. Most companies usually use them as a public relations gimmick as they never have any real benefit to a company.