Post by fastwalker on Oct 13, 2004 11:09:01 GMT -5
:)How stock splits work
;D
Stock Splits: What They Mean for Investors
Source: Bart @
Say you had a $100 bill and someone offered you two $50 bills for it. Would you take the offer? This might sound like a pointless question, but the action of a stock split puts you in a similar position.
What Is a Stock Split?
A stock split is a corporate action that increases the number of the corporation's outstanding shares by dividing each share, which in turn decreases stock price. The stock's market capitalization, however, remains the same, just like the value of the $100 bill does not change if it is exchanged for two $50s. For example, with a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share is cut in half: two shares now equal the original value of one share before the split.
Let's say stock XYZ is trading at $40 and has 10 million shares issued, which gives it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to implement a 2-for-1 stock split. For each share shareholders currently own, they receive one share, which is deposited directly into their brokerage account. They therefore now have two shares for each one previously held, but the price of the stock falls from $40 to $20 (exactly half the price).
An easy way to determine the new stock price is to multiply the previous stock price by the inverted split ratio. In this case 2-for-1 inverted becomes 1/2; multiply this by the stock price and we get the new trading price of $20. The market capitalization stays the same but it now has a different breakdown: number of shares outstanding is now 20 million, multiplied by the new price of $20 gives a capitalization of $400 million. The true value of the company hasn't changed one bit.
The most common stock splits are 3-for-2, 2-for-1, and 3-for-1. You should also know that it is possible to have a reverse stock split: a 1-for-10 means that for every ten shares you own, you get one share.
What's the Point in a Stock Split?
So, if the value doesn't change, why would a company split its stock? Good question. There are several reasons companies may consider this corporate action.
The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more attractive level. The actual value of the stock doesn't change one bit, but the lower stock price may affect the way the stock is perceived and therefore entice new investors. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before.
A final motivation for splitting the stock is to increase a stock's liquidity, which increases with the stock's number of outstanding shares. You see, when stocks get into the hundreds of dollars per share, very large bid/ask spreads can result. (Read more on the importance of the bid/ask spread here.) A perfect example is Warren Buffett's Berkshire Hathaway, which has never had a stock split. The Berkshire stock has traded as high as $80,000 (June of 1998) and its bid/ask spread can often be over $1,000.
None of these reasons or potential effects that we've mentioned jive with financial theory. If you ask a finance professor, he or she will likely tell you that splits are totally irrelevant, yet companies do it. Splits are a good demonstration of how the actions of companies and the behaviors of investors do not always fall into line with financial theory.
Advantages for Investors
There are plenty of arguments over whether a stock split is an advantage or disadvantage to investors. One side says a stock split is a good buying indicator, signaling that the company's share price is increasing and therefore doing very well. This may be true, but on the other hand, you can't get around the fact that a stock split has no affect on the fundamental value of the stock and therefore poses no real advantage to investors.
Historically, buying before the split used to be a good strategy because of commissions that were weighted by the number of shares you bought. Buying a stock before rather than after it split was advantageous only because it saved you money on commissions. This isn't such an advantage today because most brokers offer a flat fee for commissions, so you pay the same amount whether you buy ten shares or 1000 shares. Some online brokers have a limit of 2000 or 5000 shares for that flat rate, but most investors don't buy that many shares at once. The flat rate therefore covers most trades, so it does not matter whether you buy before or after the split.
Conclusion
Since it has no affect on the worth of the company, a stock split should not be what entices you into buying a stock. Buy a stock only if you think it's a good value, not because it's about to split. If the stock you like is about to split, don't worry about when to buy it, but do be aware of how the action will reduce the price and perhaps affect investors' perceptions.
;D
Stock Splits: What They Mean for Investors
Source: Bart @
Say you had a $100 bill and someone offered you two $50 bills for it. Would you take the offer? This might sound like a pointless question, but the action of a stock split puts you in a similar position.
What Is a Stock Split?
A stock split is a corporate action that increases the number of the corporation's outstanding shares by dividing each share, which in turn decreases stock price. The stock's market capitalization, however, remains the same, just like the value of the $100 bill does not change if it is exchanged for two $50s. For example, with a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share is cut in half: two shares now equal the original value of one share before the split.
Let's say stock XYZ is trading at $40 and has 10 million shares issued, which gives it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to implement a 2-for-1 stock split. For each share shareholders currently own, they receive one share, which is deposited directly into their brokerage account. They therefore now have two shares for each one previously held, but the price of the stock falls from $40 to $20 (exactly half the price).
An easy way to determine the new stock price is to multiply the previous stock price by the inverted split ratio. In this case 2-for-1 inverted becomes 1/2; multiply this by the stock price and we get the new trading price of $20. The market capitalization stays the same but it now has a different breakdown: number of shares outstanding is now 20 million, multiplied by the new price of $20 gives a capitalization of $400 million. The true value of the company hasn't changed one bit.
The most common stock splits are 3-for-2, 2-for-1, and 3-for-1. You should also know that it is possible to have a reverse stock split: a 1-for-10 means that for every ten shares you own, you get one share.
What's the Point in a Stock Split?
So, if the value doesn't change, why would a company split its stock? Good question. There are several reasons companies may consider this corporate action.
The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more attractive level. The actual value of the stock doesn't change one bit, but the lower stock price may affect the way the stock is perceived and therefore entice new investors. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before.
A final motivation for splitting the stock is to increase a stock's liquidity, which increases with the stock's number of outstanding shares. You see, when stocks get into the hundreds of dollars per share, very large bid/ask spreads can result. (Read more on the importance of the bid/ask spread here.) A perfect example is Warren Buffett's Berkshire Hathaway, which has never had a stock split. The Berkshire stock has traded as high as $80,000 (June of 1998) and its bid/ask spread can often be over $1,000.
None of these reasons or potential effects that we've mentioned jive with financial theory. If you ask a finance professor, he or she will likely tell you that splits are totally irrelevant, yet companies do it. Splits are a good demonstration of how the actions of companies and the behaviors of investors do not always fall into line with financial theory.
Advantages for Investors
There are plenty of arguments over whether a stock split is an advantage or disadvantage to investors. One side says a stock split is a good buying indicator, signaling that the company's share price is increasing and therefore doing very well. This may be true, but on the other hand, you can't get around the fact that a stock split has no affect on the fundamental value of the stock and therefore poses no real advantage to investors.
Historically, buying before the split used to be a good strategy because of commissions that were weighted by the number of shares you bought. Buying a stock before rather than after it split was advantageous only because it saved you money on commissions. This isn't such an advantage today because most brokers offer a flat fee for commissions, so you pay the same amount whether you buy ten shares or 1000 shares. Some online brokers have a limit of 2000 or 5000 shares for that flat rate, but most investors don't buy that many shares at once. The flat rate therefore covers most trades, so it does not matter whether you buy before or after the split.
Conclusion
Since it has no affect on the worth of the company, a stock split should not be what entices you into buying a stock. Buy a stock only if you think it's a good value, not because it's about to split. If the stock you like is about to split, don't worry about when to buy it, but do be aware of how the action will reduce the price and perhaps affect investors' perceptions.