1. What is a Stock Split?
2. What's the Point of a Stock Split?
3. Advantages of Stock Splits: Affordability

There are disadvantages of stock split to be aware of as a corporation. All companies that are publicly listed have a specific amount of shares that they can trade on the stock market. Doing a stock split is an action that multiples the number of outstanding shares by each share being divided, which decreases its price.

What is a Stock Split?

An example of a stock split is if you have a two for one split. For every share of stock you had before the split, you'll have two after. Even though you own two shares of stock now, each share will now be half of the original share's value. If you had one share that was worth $20 before the split happened, you'll now own two shares that are $10 each. This means the share prices become more affordable for other investors, which is the main goal of having a split.

The market capitalization for stock will stay the same, similar to how a $100 bill doesn't change in value if it gets exchanged for two $50 bills. The most common stock splits are the following:

  • Two for one
  • Three for two
  • Three for one

One way to figure out the new stock price is to take each previous stock price and divide it by the split ratio. You can also have a reserve stock split, which means in a one for ten split, you'll get one share for every ten shares owned.

What's the Point of a Stock Split?

There are many reasons a company may want to have a stock split. The first is psychology, as some investors won't buy stock as the price gets higher and will feel it's too high for them to buy, or smaller investors might think it's unaffordable. When the stock is split, it looks like it's at a level that's more attractive. However, this is just a psychological effect, as the price is essentially still the same. The stock's value doesn't change at all, but the lower stock price can affect how the stock looks and therefore gain new investors. When the stock is split, it makes current shareholders think they have more shares than they previously did. If the price increases, they'll also think they have more stock they can trade.

Another reason to split stock, and one that is more logical, is to have a stock's liquidity increase, which will increase the overall number of outstanding shares. If the stock gets past hundreds of dollars for each share, a very large bid/ask spreads can happen. An example of this is the company Berkshire Hathaway, which hasn't ever had a stock split in its history. Their bids can often be $100 or more and were at $173,000 each as of November 2013.

Buying before a split used to be a good strategy since the commissions were weighted by how many shares you bought. This had an advantage because it saved money on the commissions. There is really no need to factor in commission anymore since the majority of brokers have a flat fee for their commissions, so the same amount is charged whether 10 shares or 100 shares are bought. Online brokers might have a limit of 5,000 shares when there's a flat rate, but most investors won't buy that many at a time anyway.

However, none of these possible effects or reasons are reflected in financial theory. A finance professor will likely argue that stock splits are irrelevant, yet many companies continue to do it. Splits show how the behaviors of investors and actions of the companies don't necessarily agree with concepts in financial theory. This fact has opened up a whole new area of study known as behavioral finance.

Advantages of Stock Splits: Affordability

The main advantage of stock splits is they're affordable, as every share has improved and has half the value it did before the split. Someone may not buy a stock share for $250,000, but $125,000 seems more reasonable. The share may appeal to more potential buyers overall if every share's price is lower. More buyers and shares also mean a wider ownership base.

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