Brother, can you spare $10? (A dime isn't worth what it once was.)

No? Well, how about a pair of fives?

If you can tell that I just asked you to lend me $10, albeit in two different forms, then congratulations! You should have no problem at all grasping the concept of a stock split.

File
Once upon a time, stocks were printed on paper. Splitting them with scissors was not recommended. Photo: Wikimedia Commons.

10 on one hand, half a score on the other
In essence, a stock split is really as simple as splitting a ten-spot into two fives. Here's how it works.

A share of stock represents a share in the ownership of a company. It could be 1%, or 10%, or one-tenth of 1%. Whatever the percentage, if you take all of a company's shares and add their percentage interests together, the total is 100%. Similarly, the value of all of a company's shares, added together, equals 100% of the company's market capitalization. This is true regardless of how many shares exist today or tomorrow.

Let's take a simple example. Say your 10-year-old daughter owns a lemonade stand. She's incorporated it, and on Monday, she IPOs the company as Little Susie's Lemonade Stand (Ticker: LEMN).

Susie divides the ownership of her company into 10 shares at the IPO, each share representing 10% ownership. She keeps nine shares for herself and sells one to Timmy for $10.

Abracadabra -- Little Susie's Lemonade Stand now has a market capitalization of $100. (Each share is imputed a value equal to the price Timmy paid for his one share. Ten shares times $10 each makes $100 total value for the company.)

On Tuesday, Susie's friend Johnny -- amazed at the success of the business -- wants to buy in. Susie is happy to sell him one of her shares, but Johnny has only $5 to invest. And that poses a problem.

Problem, meet solution
Susie's solution: On Wednesday she announces that Little Susie's Lemonade Stand will split its stock in half. We call this a 2-for-1 stock split. Ten shares worth $10 each will become 20 shares worth $5 each -- and now she can sell a 5% interest in the company to Johnny for $5.

She does this, and so on Thursday, Little Susie's Lemonade Stand's ownership structure looks like this:

  • Susie is the majority holder, owning 85% of the company in the form of 17 shares worth $5 each -- $85 total.
  • Johnny is the proud owner of one single 5% share of the company, worth $5.
  • And Timmy, who owned only one share on Monday, now finds himself owning two shares of LEMN stock. But they're still worth only $10 total. They've just been split into "a pair of fives."

Notice that the value of Timmy's stake in the company hasn't changed at all. Even though he now owns two shares, each is worth only half what it was worth on Monday, and they add up to the same $10. Similarly, Little Susie's Lemonade Stand as a whole is still a $100 business.

So why do a stock split at all?
What you've just seen is an illustration of one common reason given for splitting a stock. A stock split adds "liquidity" to the market, enabling investors who could not (or were afraid to) buy a stock because its share price was too high to buy a smaller "share" of the company. What a stock split does not do is increase the value of the company -- at all.

I hope that's crystal clear by now. Before we wrap up today's column, though, there's one other reason investors might like to see a stock split: It makes it cheaper to trade stocks.

Let's put Little Susie and her lemonade stand on a shelf now and look at a couple real world examples instead. The prototypical example of a stock that "costs too much" because it refuses to split its shares is Berkshire Hathaway (NYSE:BRK-A). As I type these words, it costs $198,600 to buy one "A" share of Berkshire Hathaway. ("B" shares also exist, and they're cheaper, but let's ignore that for now.)

While it costs $198,600 to buy a share of Berkshire, the best bid price you can sell that same share for is $198,400. Were you to simultaneously buy one share of Berkshire, and sell another, you would instantly lose $200, or 0.1% of your money. (Which is not what most investors set out to accomplish.)

Conversely, a share of another big conglomerate, General Electric (NYSE:GE), can be bought right now for $23.73, or sold for $23.72. Place that trade simultaneously, and you will lose $0.01, or 0.04% on your investment -- two and a half times less.

Put another way, simultaneously buying and selling $198,600 worth of Berkshire gives you a guaranteed loss of $200 on the trade. Buy and sell the exact same value of GE, however -- 8,369 shares costing roughly $198,600 -- you would lose "only" $84.

That's a $116 argument in favor of stock splits. It's also more than Little Susie's entire company was worth. That's math, and an argument in favor of stock splits, that even a 10-year-old can understand.

Www
Photo: Steven Depolo via Flickr.

Fool contributor Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 260 out of more than 75,000 rated members.

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