The Truth about Stock Splits

The prospect that a certain stock may split to give the stockholders twice as many shares as they had before is one of the most alluring myths that surround the stock market. Although investors have more stocks after a split, the value of each share they receive is actually reduced. A company that decides to split its stocks will issue one new share for every single outstanding and will cut the value of each share in half. Even if the shares of the stockholders actually double, the total value of the stocks are still the same as before.

The reason why companies do stock splits can be explained by investor psychology. A stock with an excessively high price-per-share will cause the investors to feel that it is out of their reach. To make the shares more affordable to smaller investors, the company will opt for a stock split in order to reduce the price of the stocks. Small investors can actually buy a smaller number of pre-split shares for the same price but they sometimes opt to buy split shares due to the appeal of buying stocks for much lower prices.

There are a lot of ratios used in splitting stocks but the most commonly used are 2-for-1, 3-for-2, and 3-for-1. The reduction of the number of outstanding shares that will cause the stockholders to have fewer shares than before is called reverse splitting. Reverse stock splits are less common than stock splits. There are several reasons why companies do reverse stock splits. These may be due to an attempt to stave off possible de-listment on the stock exchange, an effort to push out minority stockholders from the company, an attempt to shed off possible consideration as a poor investment, or an effort to push through ideas of going private.

Advantages

A low price per share can result to greater liquidity since stocks with lower prices are easier to sell. This is true especially for the stocks which are priced in hundreds of dollars because small investors consider them to be out of their budget. The high bid/ask spread, which is the difference between the buying and selling prices, can also put off bigger investors.

A stock split is considered to be an indicator of a bullish market, which is a market condition wherein the prices of the stocks and the profits of the companies both increase. Even if there is a short-term rally around a stock that splits, the market tends to normalize after a short period of time. The possibility that the investors will expect the company to perform much better is one downside of stock splits. If the expectations are not met, the investors will tend to lose their confidence which will then cause a drop in the share prices.

The bottom line is that stock splits do not have any effects on the worth or the performance of a company. Although it may be nice for the investors to own more shares, they also have to face the fact that the value of their shares still remains the same.