Every company has a finite number of shares. And while people may think the number of shares are an arbitrary number of units, it holds a pivotal role in many stock related calculations. Above all it is used to calculate EPS (earnings per share) where total stock earnings are divided by the number of shares to show how much each share generates (or loses). It is also used to calculated the Market Cap which is the price per share multiplied by the number of shares outstanding.
A stock split happens when the number of shares are increased by the company.
Before we begin to answer these important questions, it is important to address that stock splits do NOT boost the value of shares. Stock splits can happen in many ratios (2:1, 3:1……) but for simple math we will be using 2:1 throughout. If a stock split is announced the investors number of shares will double but the price will be reduced in half.
So if I owned 1 share @$100 pre split --- post split I would have 2 shares @50. All other figures except EPS are unchanged. This is because there are more shares to go around.
So what would prompt a company to do this?
Make the stock more attractive
Stock splits are usually done when the price of the stock has reached very high levels. A split is usually proposed at this point as many of the small retail investors have been priced out of the market. This greatly has an impact on the trading volume and liquidity of the shares. Although smaller investors do not have high transaction volumes ($ wise), the sheer volume of retail investors as people is a huge market. By reducing the price of the shares the company is able to open their doors to a new wave of investors that would’ve otherwise not purchased shares. Regardless you should never let the price of a share discourage your investing - the human mind does not always see it this way. By making the stock more attractive it can create increased demand of the stock post split and create upward pressure on the stock.
2. Boost the Liquidity
By having more and cheaper shares (dollar wise) on the market, this opens up the company to a whole new group of investors that would have shied away from purchasing the stock before because of the higher price. If we take Apple for example - Apple was trading at $700 a few years ago and now trades at $200. A few years back they did a 7:1 split and brought the price down to $100. The $100 price point is a lot more appealing for investors as psychologically you are receiving 7 shares as opposed to 1. For some investors it is also a lot more palatable to spend $100 per share than $700. Although price should seldom be the issue unless we are talking about BRK.B, psychology plays a huge role in the markets as well. By opening up the shares to a whole new group of investors - this boosts the trading volume of the shares creating more liquidity as the market has more participants. It will also narrow the bid-ask spread which is a key to liquidity.
We can go the other way as well…
Now splits do not work just by going one way. Companies also engineer reverse splits which means they augment the price of the share by reducing the overall # of shares. Say I had 10 shares worth a dime each. A reverse split would mean post split I only have one share worth $1 after the split - effectively a 1:10 split. Companies will usually do that to maintain minimum listing requirements for certain exchanges. For examples the DOW and NASDAQ do not allow companies. These requirements include rules on dollar values and EPS. Companies will also do reverse splits as the sheer impact of the marketing effect from being on the dow/nasdaq is immense as those markets receive the most viewership as they are most known to investors.
Disclaimer: All of the above information is my own personal opinion. Examples used are for educational purposes only. Please do your research before making any investment decision.
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