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What Is a Stock Split and Why Do Companies Do Them?

By Motley Fool Staff - May 15, 2016 at 10:00PM

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With stock splits, the pie stays the same size and the company is just cutting it into more pieces.

Stock splits have been making news in the tech sector recently, especially after Facebook's (FB 1.39%) most recent earnings call.

Stock splits are often not well understood by investors. Shareholders tend to like them in part because a split creates the impression of owning more. Of course, having a 2-for-1 split does not mean you're getting twice as much. It means a shareholder will now have two shares that are equal to what one was previously worth.

In this segment from the Industry Focus podcast, Sean O'Reilly and Dylan Lewis explain what a stock split does to a company's shares and why companies do them.

A transcript follows the video.

This podcast was recorded on May 6, 2016. 

Sean O'Reilly: We're talking about not necessarily a tech theme today, but it obviously affects a couple of tech companies, which we'll be talking about. We're talking about stock splits. Dylan, for our listeners who may not know, what is a stock split?

Dylan Lewis: A stock split is basically, if you think about a company's value and their ownership as a pie, stock splits take that pie, and, if it's cut into 1/8ths to start, it cuts it into 1/16ths.

O'Reilly: What kind of pie is it?

Lewis: I like to think it's a pecan pie.

O'Reilly: Pecan pie. (laughs) 

Lewis: So, if you owned 1/8th of that pie, and it was a 2-for-1 split, you would now be getting two slices of 1/16th pie. 

O'Reilly: (sighs) Why do people do this, Dylan? (laughs) 

Lewis: There are a couple different reasons companies do it. Some of them I put credence in, and some of them I don't, personally. But the idea here is you're making your shares slightly more accessible to the average investor, because the overall value of the company doesn't change, and you're just getting smaller slices. Say you're currently trading at $100 a share. If they do a 2-for-1 split, they're now trading at $50 a share and you have two shares in your account.

O'Reilly: What's your opinion on that? Everybody's favorite example of this is Warren Buffett's Berkshire Hathaway (BRK.A 1.75%) (BRK.B 2.02%). Not everybody has $200,000 to just buy one share of something. What do you think about that?

Lewis: I think there's something to be said for keeping your share prices high, and having people who are buying and holding and not moving in and out of positions. I think it does attract a certain type of investor. I do think it's nice when companies decide they want to make their shares more accessible to the average investor. Tim Cook, when Apple (AAPL 4.01%) split 7-for-1, said, "We're taking this action to make Apple stock more accessible to a large number of investors." He made it plain and simple that that was part of the motivation for it.

One of the other things people will cite is it does increase liquidity, if for some reason you're seeing wide bid-ask spreads -- what people are willing to sell for versus what people are willing to buy for in brokerage accounts, or the brokerage teams that pair those up. You'll see those spreads tighten up.

O'Reilly: That seems like kind of a dubious claim today, because of the proliferation of technology in the financial industry. All trading is done by algorithms.

Lewis: Especially because most companies that are splitting already have a pretty big daily active volume, and it's not something that will dramatically change that. So I don't know how much I believe that. But the last line of thinking -- and, again, this is one that is not super relevant maybe as much anymore, but board lot thinking and the strategy there. A board lot is the standardized number of shares as defined by a stock exchange as a trading unit.

Basically, you think about some of these big institutional moves and brokerage moves that happen. The purpose of these board lots is to avoid odd amounts of shares. If everyone is working in these 100-share denominations typically, then you won't wind up with these weird 83-share lots that no one wants. It makes it easier to get a collection of 100 shares for that board lot if the share price is lower.

O'Reilly: Got it.

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Berkshire Hathaway Inc. Stock Quote
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Meta Platforms, Inc.
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Berkshire Hathaway Inc. Stock Quote
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