Suppose you have a $100 bill and someone offers you two $50 bills in exchange. Would you accept the offer? The question does not seem to make sense, but it serves to illustrate what happens with the division of stocks.
In this article, we are going to explain to you what the stock split consists of, why it is done, and what it means for investors.
What is a stock split?
A stock split is a corporate stock that increases the number of outstanding shares of the company by dividing them, which in turn lowers their price. The market capitalization of the stock, however, remains the same, just as the value of the $100 bill does not change if it is exchanged for two $50 bills. For example, with a 2-for-1 share split, each shareholder receives an additional share for each share owned, but the value of each share is halved: two shares are now equal to the original value of one share before the split.
Let's say Company A's stock is trading at $40 and it has 10 million shares issued, giving it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to carry out a 2-for-1 share split. For each share that shareholders currently own, they receive an additional share, deposited directly into their brokerage account. Now they have two shares for each of them, but the price of the shares is reduced by 50%, from $40 to $20.
Note that the market capitalization of the company remains the same - it has doubled the number of shares to 20 million - while simultaneously reducing the price of the shares by 50% to as much as $20, maintaining the capitalization of 400 million dollars. The real value of the company has not changed at all.
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The most common stock splits are 2-for-1, 3-for-2, and 3-for-1. An easy way to determine the price of the new stock is to divide the price of the old shares by the division ratio. In the case of our example, divide $40 by 2 and you will get the new price of $20. If a stock were divided with a 3-by-2 ratio, we would do the same: 40 / (3/2) = 40 / 1.5 = $26.6. It is also possible to do the reverse process: a 1-in-10 means that for every ten shares you own, you will get one share.
Here we will illustrate exactly what happens to the most popular divisions in terms of the number of shares, the price of the shares, and the market capitalization of the company that carries out the division.
For what purpose are the stock splits carried out?
The first reason is merely psychology. As the price of a stock gets higher and higher, some investors may feel that the price is too high to buy, or small investors may think that it is unaffordable. The division of the stock makes its price more "attractive". This effect is purely psychological. The real value of the stock does not change, but a lower price can affect its perception, and, therefore, attract new investors. The stock split also gives existing shareholders the feeling that they suddenly have more shares than before, and of course, if prices go up, they have more shares to trade.
Another reason and possibly more logical than the previous one, for dividing a stock is to increase the liquidity of a company, which increases with the number of shares outstanding. When stocks reach a very high price, the difference between the bid and ask price can be very high.
A perfect example is Warren Buffett's Berkshire Hathaway (NYSE: BRK.A), which has never split its shares. Its bid/ask spread typically exceeds $100, and as of November 2013, its Class A shares were trading at just over $173,000 each. However, neither of these reasons is compatible with financial theory. Any finance professor will tell you that divisions are totally irrelevant, but companies still do.
The splits are a good demonstration of how the actions of companies and the behaviors of investors do not always coincide with financial theory. This fact has led to the emergence of a new area of financial study called "behavioral finance."
There are many opinions for and against whether the stock split is good or bad for investors. On the one hand, there is the idea that a stock split is a good buy indicator, suggesting that the company's share price is increasing, and therefore things are going well for it. This may be true, but on the other hand, a stock split simply has no effect on the fundamental value of the stock and therefore does not represent any real advantage to investors. Despite this fact, analysts often speak positively about divisions. There are even entire publications dedicated to tracking stock splits in order to profit when they occur. Critics say this strategy doesn't stand the test of time.
In the past, buying shares before splitting was a great strategy, as brokers charged their commissions based on the number of shares purchased. It was advantageous only because it saved you money on commissions. However, this strategy is no longer effective today, as most brokers charge the same commission regardless of the number of shares purchased. Some online brokers have a limit of 2,000 or 5,000 shares, however, most investors do not buy that many shares at once.
Remember that stock splits have no effect on the market capitalization of the company. A stock split should not be the deciding factor in determining whether or not you buy a stock. Although there are some psychological reasons why companies split their shares, this move does not affect the company itself. After all, two $50 bills are worth the same as one $100.
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