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 Investors that are new to the stock market may have heard the term "stock split" and not completely understood what the term means. In this article we're going to help define what the market calls stock splits and reverse stock splits. We're also going to walk through an example of what happens after a stock split, and how a split can affect the dividends paid to investors.
Stock Split Definition
A stock split is defined as an adjustment to the number of shares outstanding. If you've ever heard of a 2 for 1 stock split, what this is telling the investor is that the company has supplied to the market 2 shares of stock for every one share outstanding. It's also possible to have a reverse stock split, which we will discuss later on.
Splitting a Stock
There are some pretty good reasons for a company to split its stock. As a stock rises in price over time, some investors may become unwilling to pay such a high price for a share of stock. This is more of a psychological barrier than a value-based hurdle.
By splitting a stock, a company hopes to entice more investors back to the company's stock. This is why most companies announce splits when the stock price approaches historical highs. So how exactly does this process work?
The first step is for the company to publicly announce the stock split, giving the exact date the split will occur. The holders of stock on this record date are entitled to the split in shares. There are several common types of splits - 2 for 1 and 3 for 2 are probably the most common. In a 2 for 1 stock split, the company is stating that it will have 2 shares outstanding for every 1 share currently issued.
Stock Split Example
Let's say that the company currently has 100 million shares outstanding and the company announces a 2 for 1 stock split. Let's also assume that on the day before the stock split the company's stock closes at $50 / share. On the day of the split, the company will have 200 million shares outstanding and the likely opening price will be $25 / share.
If an investor owns stock in a company and they announce a stock split, the investor is automatically credited for the split. In the above example, if an investor owned 100 shares of stock prior to the split, they would own 200 shares of stock after the split.
Valuation and Stock Splits
As previously mentioned, stock splits do not mean there has been any change to the underlying value of the stock. Earnings and net income for the company may have been growing over time, but nothing special happened on the day of the split.
Stock Dividends and Stock Splits
The stock dividend policy of a company is therefore directly affected by a stock split. For example, a stock that was paying $2.00 / share dividend before a 2 for 1 split will likely be paying a $1.00 / share dividend after the split. From an accounting standpoint nothing has changed except the number of shares of common stock. So with twice as many shares outstanding the dividends paid must be cut in half.
Many investors view stock splits as a positive sign for a company - even those that can rationalize the fact there has been no change to the intrinsic value of the company. These rational investors see stock splits as a positive sign for a company because the price is trading near historical highs, good news is usually on the horizon, and the split makes the stock more affordable to investors.
Reverse Stock Splits
Finally, stock splits can also happen in reverse. Lucent Technologies was faced with this decision several years ago when its price per share fell below $1.00 per share. When a company's shares fall below $1.00 per share, as did Lucent's, the company is at risk to be de-listed from the stock exchange on which it trades.
To bolster it stocks price, Lucent considered doing a 1 for 20 or 1 for 30 reverse stock split. If the company had decided on a 1 for 20 reverse stock split, investors holding 200 share of stock before the split would have owned 10 shares after the split.
Understanding which companies have undergone recent stock splits can also be important to investors researching stocks. When looking at a company's current price per share, a stock that has split in the last 52 weeks can be identified by looking for an "S" that should appear after the company's name.
About the Author - Stock Splits
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