Island Investing: Stock Splits

Q. Why do companies split their stock?

A. A stock split is a decision made by a public company to increase the number of shares outstanding by dividing them into multiple shares. In a 2-for-1 stock split, for instance, every stockholder will receive one additional share for each share currently held. Because stock splits are purely a cosmetic change, however, the price of each share is also reduced during a split.

If a company had 5 million shares trading at $10 before a split, it will have 10 million shares priced at $5 afterwards. As the owner of a stock that splits, the value of your shares remains the same. You get more shares, but each is worth less. It’s like being given two ten-dollar bills in exchange for your twenty.

Less common is a reverse split, which decreases the number of shares outstanding while increasing the share price. This, too, is a mathematical exercise, as the value of an investor’s holdings remains unchanged. From an analytical perspective, neither a stock split nor a reverse split mean very much.

A stock split can have considerable meaning in terms of investor psychology, however. Stock splits often get more attention then they might otherwise deserve because of the signal they send. More specifically, a stock split is often viewed as a bullish sign from company management. After all, it wouldn’t make much sense for a company to split its stock if it expected the price to go down.

That signal probably best explains the rationale behind stock splits. While some splits are done to increase the liquidity of a company’s shares, and others to meet stock exchange requirements, most stock splits are done for one reason: to make a company’s shares more psychologically appealing.

As the price of a company’s shares gets higher, some investors may view shares as unaffordable. A stock split brings the price down to a more “attractive” level. While that’s a completely irrational response, since the value of the stock doesn’t change, companies sometimes do count on emotion rather than logic to attract new investors. Don’t be swayed.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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