Friday, January 22, 2016

Stock Splits: How they Work

When a company does a stock split, it means that it increases the number of shares outstanding by splitting the existing stock.
So, for example, if a company has 100 million shares outstanding, and they are worth $100 each, then the company is worth $10 billion. If they do a 2:1 stock split, then there will now be 200 million shares outstanding. Since the value of the company itself should be unaffected (nothing fundamental about the company is changing, at all), the company should still be worth $10 billion. So, the shares should now be worth $50 since there are 200 million shares outstanding.
Companies can do other kinds of split as well, such as 2:3 splits. They can even do reverse splits, where there are now fewer shares rather than more shares.

Stock Splits Do Not Affect Value

It’s a misconception that a stock split is valuable. It should not affect value, because nothing about the company actually changes. It’s like trading a dime for two nickels; there may be reasons to do it, but it’s still worth ten cents.
-Stock splits can increase stock liquidity by making the share prices cheaper. Each share is worth less of the company, so each share is cheaper now.
-It’s speculative whether stock splits have a psychological impact on investors. It could be the case of a self-fulfilling prophecy regarding increased value after a stock split.
-Option contracts that rely on trading 100 shares at a time can be affected by the price of a stock; it’s a liquidity issue again.
So while there are various things that a stock split can affect, it doesn’t change the value of the company itself.

Stock Splits Compared to Share Repurchases

Unlike stock splits, share repurchases do affect value. When a company repurchases its own shares, it reduces the number shares outstanding, and therefore each remaining share is now worth a larger percentage of the company. With a share repurchase, the remaining owners basically “buy out” the owners that sell their stock back to the company, and so the holding value of the company changes hands a bit.
But with a stock split, there isn’t any changing of hands. Each investor’s shares get multiplied based on the agreed upon stock split.

This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]


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