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.
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.
Bull Bear Markets
Bull and Bear are the terms to describe the general conditions of the stock market. These do not refer to...
Types Of Trading
The stock market also provides opportuni...
Most stock trades are done through a broker an intermediary who takes orders and executes th...
The 'Stock Exchange' is the correct term for the physical location for t...
All of these factors – low price, lack of standards, and lack of stability – make ...
Stocks Trading Signals
Investors who treat trading as a full-ti...
Stocks Vs Bonds
Bonds always carry the risk that the principal amount may n...
Stock Trading Strategies
HedgingHedging is a way of protecting an investment by reducing ...
The basis for technical analysis is the belief that stock prices move in predictable patterns. All the ...
A contract to buy is called a 'call option'. The buyer of a call option hopes the price of the underlying stock will...
There are many different stock indexes, the most common in the United...
Fundamental Analysis 2
Earnings per ShareThe overall earnings of a co...
The goal of fundamental analysis is to determine how much money a co...
To a certain extent stock prices are determined by investor confidence but that confidence in turn i...
Technical Analysis 2
These perks are not free – full service brokers charge t...
Stocks Vs Mutual Funds
What is the advantage of a diversified portfolio? It offers protection against rapi...
Pink Sheets Stocks
Penny stocks are securities that are less than $5 in value. Although they can be traded on regular sto...