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The Purpose and Effects of Stock Splits: Theory and Practice

written by: John Garger•edited by: Jason C. Chavis•updated: 9/23/2010

For various reasons, it is not uncommon for corporations to split stocks. Investors must be aware of the effects a stock split has on a firm’s value.

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    The total value of a company can be estimated by multiplying the price for a share of stock in the company by the total number of shares outstanding. This figure takes into account all relevant information about the corporation’s profitability and the confidence investors have in the firm realizing positive outcomes. Occasionally, a company finds itself with a need to change the number of shares of stock outstanding. As a representation of partial ownership of the firm, it is important for investors to know the effects of splitting stock and what it means to current and future ownership.

    A stock split is a re-proportioning of the value of a share of stock so that there are more shares outstanding and each individual share of stock represents a smaller claim to the total value of corporation. It is common for a company to initiate a 2-for-1 stock split in which the number of shares outstanding doubles and the value of the resulting total number of shares halve.

    Suppose a company has 1,000,000 shares of common stock outstanding and the stock is currently trading in the market for $60 per share. The estimated total value of the firm would be:

    1,000,000 * 60 = $60,000,000

    Now suppose that the managers of the corporation decide to initiate a 2-for-1 stock split. The number of shares outstanding is changed to 2,000,000 and the stock price immediately drops to $30 so that the total value of the firm remains unchanged:

    2,000,000 * 30 = $60,000,000

    A stock split is nothing more than a change on paper to facilitate certain advantages. Each current stockholder’s holdings of stock double so that the proportion of the firm owed by the investor is the same both before and after the stock split. No loss of value is borne by the current stockholders.

    The purposes of a stock split are numerous but one major reason for the split is to facilitate easier trading of a company. Most stocks in the New York Stock Exchange trade for between $10 and $60. When a company experiences growth, initiating a stock split allows each individual share of stock to trade for a lower price thereby allowing both small and large investors to invest money in the company. Sometimes shares of stock are sold in large blocks such as 10,000 shares at a time regardless of their total value. By lower the price per share, these blocks become cheaper and investors can take advantage of the lower price per quantity.

    The problem with stock splits is their effects on historical data. When a stock splits, the value of a share of stock is reduced. On a chart of share prices, a stock would appear to lose half its value instantly in a 2-for-1 stock split. Therefore, adjustments are made to previous periods’ stock price to act as if the past number of shares outstanding were the same as the current number. This way, investors do not have to worry about making extra calculations to account for the changes in price brought on by a split.

    A stock split often sends a signal to the market that the managers of a corporation are expecting high returns in the near future, the stock split being a pre-emptive move to prepare for the increase in demand for its shares. It is common for the value of a firm to be estimated slightly higher after a stock split because of this signaling effect.