A stock split simply involves a company altering the number of its shares outstanding and proportionally adjusting the share price to compensate.
A stock split in no way affects the intrinsic value or past performance of your investment.
Let's take a typical example: a 2-for-1 stock split. A company will announce that it's splitting its stock 2-for-1 in one month. One month from that date, the company's shares (having traded the day before at, say, $100) will now be trading at half the price from the previous day (so they'll open at $50). The company, which had 10 million shares outstanding, now consequently has 20 million shares outstanding. The price has been halved in order to accommodate a doubling of the share total within the same market cap.
Why do it?
Many investors believe, for whatever reason, that share prices in the range of (roughly) $20 to $100 are worth purchasing. Get much above that and the shares are viewed as "too expensive." Well, considering that you own the same percentage of the company if you have 1000 shares out of 100,000,000 versus 2000 shares out of 200,000,000 (0.001% in each case), it doesn't matter one whit if the first set is priced at $120 each and the second is at $60 each. In each case, you've got $120,000 out of $12 billion. But, people think the $60 shares are somehow "cheaper."
Many companies pander to this idea and try to keep their stock price somewhere within that $20 to $100 range. Considering that splitting shares involves a significant expense (tens or hundreds of thousands of dollars), shareholders might question why the company is spending money that way.
There is some evidence, however, that splitting the stock increases liquidity. That is, more people buy or sell it more often. This often is a good thing as it reduces the bid-ask spread on a percentage basis (more highly liquid stocks generally have a smaller spread).
Companies also use a stock split as a signaling mechanism. Again because of the belief that a double-digit price is "better" and that it is easier for the share price to increase from a $30 price than from a $300 price, the perception by many investors is that when a company splits its shares, it believes that there is more room to rise.
However, a good metaphor to bear in mind is to imagine having a pie. If you cut the pie into four pieces, you still have the same amount of pie.
When a company splits its shares, it recalls all the shares outstanding, and then issues more new shares to replace those. For a 2-for-1 split, using the example above, it would recall all the 10 million shares, and then issue 20 million shares in replacement, worth half as much each.
In the equity portion of the balance sheet, the number of shares outstanding is increased and the par value per share is decreased. The total dollar amount in the account "Stock at par" remains unchanged. See? The company knows there's no effective change.
For shareholders, the per share basis is reduced by the same ratio. For a 2-for-1 split, if the basis was $880 for 200 shares ($4.40 per share), the new basis would be $880 for 400 shares ($2.20 per share). Then if you sell 100 of those shares at $3.00, you would record an $0.80 per share capital gain.
Sometimes, the company issues a stock dividend instead of a split. To know if this is the case, look at the announcement for the split. It will read something like, "The company will effect the stock split in the form of a stock dividend." In this case, the par value of the stock and number of shares remains the same, but the contributed capital account increases, paid for by a decrease in the retained earnings account.
In a stock dividend situation, your basis is adjusted downward depending on the amount of new stock received and the original basis of the stock originally owned. For instance, for a 25% stock dividend, if you had 200 shares at $40 each, your new basis would be $32 each for 250 shares ($8,000/250). This works out to the inverse of the new number of shares. That is, you now have 125% of the shares you started with (250/200), at 80% of the price each (32/40).
We at The Motley Fool get a tiny rise in our steps when we hear one of our stocks is splitting. It's kind of... fun. You get more shares (all of them adjusted to a lower price). Your company might get written up in the news. You'll get a few back-slaps at your local watering hole. And that's about it.
Don't get caught up in the (largely ignorant) hysteria that many others feel. For years, David and Tom Gardner on their Motley Fool Radio Show took calls from people who would ask, "Do you think Intel will split?" The subtext of the question -- what the caller actually meant to say -- was "Do you think Intel will rise?" or "Do you think Intel will do well this year?" David and Tom would essentially take their audience through the logical thinking laid out above. "Would you like to eat the peanut butter sandwich straight up?" they would ask. "Or would you like us to slice it in two first?"
Related Fool Articles
Recent Mentions on Fool.com
- General Electric CEOs: How Jeff Immelt Measures Up to Jack Welch's Legacy
- 3 Stocks That Just Raised Their Dividends
- These Stocks Just Raised Their Dividends
- Everything You Need to Know About Apple Inc.'s Record High Share Price
- Why This Billion Dollar Fund is Betting Big on Microsoft Corporation Stock
- Apple, Inc. iPhone: The Hidden Risk in Its Success