Stock Splits Explained
The ultimate definitive column on Splits, Part I

By Barbara Eisner Bayer (TMF Venus)

[Editor's Note: Ann Coleman is on vacation through August 26.]

WOODSTOCK, NY (August 10, 1999) -- The concept of "splits" conjures up memories of: (1) leggy ballet dancers extended in non-human positions; (2) mouthwateringly fattening ice cream concoctions smothered in whipped cream, nuts, and the goo of your choice; and (3) embarrassing accidents with pants resulting from number (1) eating too many of number (2).

Stock splits have nothing to do with any of the above. They are a simple process companies employ for a variety of reasons, which will be detailed below. Still, they cause great confusion for many investors. To clear the confusion, I give you the Definitive and User-friendly Foolish Column on Stock Splits, Part I.

What exactly is a stock split?

It's an increase in a company's number of outstanding shares of stock without a corresponding increase in assets. (Outstanding shares are the number of shares of capital stock that have been issued and are in public hands, and the number of outstanding shares is used in the calculation of book value per share and earnings per share.)

Confusion occurs because some people think that when a stock splits they are getting something for nothing. Ah... if only! A typical misunderstanding of splits goes something like this:

"Let's say I have 200 shares of a stock that is trading at $50 a share. That's an investment of $10,000. So I thought if it split, I would have 400 shares of it. I thought that meant 400 shares of a stock that was $50 a share, which means I would then have $20,000."

Oh� I wish, I wish, I WISH it were so. But it's not. Since there's no increase in a company's assets when a stock splits, the price of each share must therefore decrease proportionate to the increase in shares. Our reader delighted in getting twice as many shares, but forgot that the price of each share would be decreased by half. Therefore, while it's true she would be getting 400 shares, each share would now be worth only $25.

The same reader went on to say:

"A lot of my friends work at America Online (NYSE: AOL), and every time their stock splits, they get so excited and they all say they will be able to retire after it splits 4 or 5 more times because they keep watching their money double."

This is a perfect example of people engaging in wishful thinking.

Splits are really meaningless, as they don't affect the underlying value of the stock AT ALL! This reader's friends are probably being overzealous, because AOL stock has performed well in the past; but the past is not necessarily an indicator of the future. The problem with this logic is that there is NO GUARANTEE AOL stock will rise and split again. It can just as easily drop. And even if it does rise, it could take 2-10 years.

Imagine this scenario: It's the early part of the century and your best buddy Picasso hasn't been faring well selling his funny paintings on the banks of the Seine. You decide to help by buying him a new canvas to work on. The canvas costs you $10.00.

Picasso, always the innovator, figures that if he divides the canvas in half, he'll have TWO possible paintings for sale. You now have two empty canvases for the price of one. Your financial investment is still worth $10.00, but Picasso now has an extra canvas to paint on.

The value of your investment hasn't changed at all. Perhaps WAAAAAY down the road, if Picasso ever amounts to anything and his artwork becomes valuable, you will have 2 paintings to sell instead of one. Then it's possible each painting will be worth more. But that will be only after additional value is added by Picasso's painting of each canvas.

So why do companies split their stock?

Sometimes it's done to increase the liquidity of the stock, as a split results in more shares in the marketplace. This can result in reducing the Bid/Ask spread and making it easier to trade.

Sometimes it's done so a company can offer its staff more shares as bonuses or through stock options, which can often attract higher quality employees as part of an overall compensation package.

Sometimes it's done because the company has been performing well, is excited about its future prospects, and wants to communicate this fact subtly to the investing community. Often splits occur in the face of new highs for a stock; thus it's an event dripping with positive associations. Many investors are psychologically unwilling to pay that "high price," and a stock split brings the shares down to a more attractive level. The irony here is that it only APPEARS that way; in reality, the value of the stock hasn't changed one bit.

For Foolish Four investors, a stock split is a non-event. Just adjust the amount of shares in your portfolio and their cost basis -- you will see it won't affect the dollar value at all.

Next Week: Cost Basis, Record Dates, and Accounting for Splits

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08/10/99 Close
Stock  Change   Last
CAT  +1  1/8   58.88
JPM  -3        121.94
MMM  +   1/2   95.25
IP   +   1/4   50.50

                  Day    Month   Year   History
       FOOL-4   +0.25%   0.88%  23.99%  25.83%
        DJIA     -0.49%   0.00%  16.84%  16.37%
        S&P 500  -1.26%  -3.56%   4.83%   5.08%
        NASDAQ   -1.15%  -5.62%  13.56%  15.12%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     58.88    36.66%
 12/24/98   14 3M            73.57     95.25    29.47%
 12/24/98   22 Int'l Paper   43.55     50.50    15.96%
 12/24/98    9 JP Morgan    105.51    121.94    15.57%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1413.00   $379.00
 12/24/98   14 3M          1030.00   1333.50   $303.50
 12/24/98   22 Int'l Paper  958.12   1111.00   $152.88
 12/24/98    9 JP Morgan    949.62   1097.44   $147.82

              Dividends Received      $49.99
                             Cash     $28.26
                            TOTAL   $5033.19