How do stock splits work?

You might have heard about them in the financial media or they could be causing you some confusion in your personal portfolio. So we get the question a lot: How do stock splits work?

You can think of a stock split as a cake that’s been sliced into eight pieces — it’s the same delicious cake, just cut into smaller bits.

When a company splits its stock, it’s just dividing its existing shares into more, lower-priced shares. But even though the number of shares outstanding increases, nothing happens to the company’s intrinsic value.

That’s because the share price is reduced in proportion to the number of new shares issued. Double the shares, half the share price. Triple the shares, one-third the share price. You get the picture.

Let’s look at a hypothetical example …

Monkey Mittens Inc. has 100 million shares outstanding, each trading at $100. One day, the board of directors decides to implement a 2-for-1 stock split. After the split takes effect, the company will recall all 100 million shares and then issue 200 million in replacement, worth half as much ($50) each.

See why the company’s underlying value isn’t changing? The market capitalization — shares outstanding multiplied by share price — is $1 billion both before and after the split. It’s math.

What does a split mean for shareholders?

Say you own 40 shares of Monkey Mittens. Once the split takes effect … poof! You now see 80 shares in your brokerage account! You’ve hit the jackpot, right?

Sadly, no. Your investment “cake” has just been cut into slices.

For all intents and purposes, stock splits don’t affect shareholders. Actually, they’re kind of a non-event … at least as far as you’re concerned. Even though you’ll have more shares, the price will be reduced proportionally — which means the total value of your investment won’t change.

Before the split, you owned 40 shares of Monkey Mittens, each priced at $100. Now, after the split, you own 80 shares, but each is priced at $50. Same total investment.

If you’re wondering about the tax consequences of a stock split … there are none. Since your equity doesn’t change, neither do your tax payments.

Stock splits don’t affect your total dividend payment, either. The company will probably just lower the amount it pays out per share to adjust for the increase in shares outstanding.

Why do companies split stocks?

1. Affordability

The conventional explanation is that companies split their stock in order to attract a wider pool of shareholders. By lowering the share price, they hope to make the stock appear more affordable for your average investor.

For whatever reason, some investors target stocks priced between $20 and $100 per share. Get much above that and the shares are deemed “too expensive.” So if a company sees its share price rise above this level, it might execute a stock split to make the stock seem more affordable.

The effect is purely psychological, though — you’re not actually getting more bang for your buck. The value of the stock isn’t changing. Whether you buy 10 shares at $10 or 20 shares at $5, you’re still going to have $100 invested in the company. But for some investors, the second scenario screams bargain.

2. Liquidity

Another motivation for a company to split its stock is to increase its liquidity, AKA make people buy and sell it more often. In theory, a stock split should accomplish this by reducing the share price and increasing the number of shares on the market.

Having a highly liquid stock is good for a company’s economic growth because it reduces the risk of that stock falling prey to market manipulation through domination by one or two big traders. It’s good for you, too. When there’s a high trading volume, you can easily move out of your position … even if you own a large number of shares.

Are stock splits a buy signal?

It depends who you’re asking. There’s been a lot of research over the years about the performance of split stocks, but the results have been mixed.

One side says a stock split is a no-questions-asked buy signal. Many think it indicates that a company is doing well and that it’s expecting to keep doing well … after all, why would it create room to rise if it weren’t expecting to rise? Some just think it comes down to supply and demand principles — a stock that appears cheaper will intensify demand and thereby drive up stock price.

Critics, on the other hand, argue that stock splits don’t have any effect on a stock’s performance — after all, they don’t do anything to the company’s fundamental value. They may lead to short-term price spikes thanks to media hype and renewed investor attention, but they shouldn’t have any effect on long-term price appreciation.

The Foolish take

Frankly, we consider stock splits to be the one of the most overrated topics in equity investing.

Investors everywhere get way too fired up about stock splits, to the point that they risk being manipulated by companies that are just trying to juice speculative buying. For some reason, many investors believe that having more shares is somehow better … and that even though many brokers allow you to buy fractions of shares, stocks with a higher price tag are “expensive.”

Nay!

We’re not saying that you should totally ignore stock splits.

But short-term speculative buying based on a largely cosmetic change isn’t a sustainable investing strategy. Whenever you’re dealing with stock splits, just remember: a slice of pizza will only taste as good as the pie it came from.

— Answer provided by Motley Fool intern Caroline Jennings

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