Stock split

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Traders consider splits a positive progression in value and goodwill for companies and their investors. Corporate executives use stock splits as marketing and investor relation tools. They know that stock splits make shareholders feel better and engender a sense of greater wealth.

Stock Splits is an increase in the number of outstanding shares of a company's stock, such that proportionate equity of each shareholder remains the same. This requires approval from the board of directors and shareholders. A corporation whose stock price is really good in the share market could very well use the option of splitting its shares. This action results in issuing supplementary shares to existing shareholders. The most common stock split is two-for-one, in which each share that a shareholder holds becomes two shares. So, if a company had 10 million shares outstanding before the split, it will have 20 million shares outstanding after a 2-for-1 split. Since buyers and sellers of the stock already know about the stock split, the price per share immediately adjusts to reflect the stock split. Some of the companies in the market decide to split their stock if the price of the stock rises to a great extent and is supposed to be too expensive for small investors to afford.


Different types of stock splits

Forward stock splits

The term forward stock split is defined as when any company will announce a stock split, the price of the stock will decrease; however, the number of shares will increase proportionately. For example, if you own 100 shares of XYZ Company that operates at $100.00 a share and it announces a two for one stock split, you will own a total of 200 shares at $50.00 after the split. Although many stock splits are two for one, companies can split their stock in any number of ways, including three for one, three for two, and so forth. The stock market average returns for these new shares will reflect the ratio that was used in the split.

Advantages of Forward Stock Splits

The most important reason for a company to use this stock market strategy is to increase liquidity of the stock. Although there are investors buying certain companies stock at over $500 per share, many more investors would be inclined to buy if there were five times more shares at $100 per share. This tactic is employed by many companies when their stock sales come to a standstill because of the consistent increase in the prices of their stocks. If the stock doesn’t stall companies will typically allow the price to rise, as indicated by some companies over $500 per share.

Reverse stock splits

Reverse stock splits are less likely to be used by the companies as they show somewhat of a negative investment strategy attached to them. The reverse stock split is defined as the stock split under which a firm’s number of shares outstanding is reduced. If the price of a stock for a certain company drops too low, many mutual funds will not purchase them. Therefore, by having the low prices for their stocks, they run the risk of being delisted, or even being removed from the market indexes. In addition, the low stock prices of a company would create a psychological stigma as buyers and sellers view them as worthless. By doing a reverse stock split, companies can raise the stock price by lowering the number of outstanding shares; therefore, eliminating the problems caused by the low stock prices.

Advantages of Reverse Stock Splits

There are three reasons why a company would want to go for a reverse stock split. First of all, the transaction costs to the shareholders would be less after the reverse stock split. Secondly, the liquidity and marketability of a company’s stock might be improved when its price is raised to the popular trading range. Finally, Stocks selling at certain price below a certain level are not considered respectable which means that the investors underestimate these companies earnings, cash flow, growth, and stability. Some financial analysts argue that a reverse stock split can achieve instant respectability. A reverse stock splits reduces the number of shares and increases the share price proportionately. For example, if you own 10,000 shares of a company and it declares a one for ten reverse split, you will own a total of 1,000 after the split. A reverse split has no affect on the value of what shareholders own. Below we illustrate exactly what happens with the most popular splits in regards to number of shares, share price and market cap of the company splitting its shares.

Pre-Split Post-Split
2 For 1
# of Shares 10 Million 20 Million
Share Price 10 Million 5 Million
Market Cap 100 Million 100 Million
3 For 1
# of Shares 10 Million 30 Million
Share Price 10 Million 3.3 Million
Market Cap 100 Million 100 Million
3 For 2
# of Shares 10 Million 15 Million
Share Price 10 Million 6.6 Million
Market Cap 100 Million 100 Million
Reverse Split
1 For 10
# of Shares 10 Million 1 Million
Share Price 1 Million 10 Million
Market Cap 10 Million 10 Million

Why do companies splits their stocks?

Now, one might have a question, if the value of the stock doesn't change, what motivates a company to split its stock? There are several reasons because of which companies consider carrying out this corporate action.

The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel that the price is too high for them to buy, or small investors may feel that it is unaffordable. Splitting the stock brings the share price down to a more attractive level. The effect here is completely psychological. The actual value of the stock doesn't change at all, but the lower stock price may affect the way the stock is perceived and therefore persuade some new investors. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before, and obviously, if the price of the stock rises, they have more stock to trade.

Another reason, and arguably a more logical one, for splitting a stock is to increase a stock's liquidity, which increases with the stock's number of outstanding shares. When stocks get into the hundreds of dollars per share, very large. A perfect example is Warren Buffett's Berkshire Hathaway, which has never had a stock split. At times, Berkshire stock has traded at nearly $100,000 and its bid spread can often be over $1,000. By splitting shares a lower bid spread is often achieved, thereby increasing liquidity. None of these reasons or potential effects that we've mentioned agree with financial theory; however, if you ask someone with knowledge in finance, he or she will likely tell you that splits are totally irrelevant - yet companies still 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.

Examples

Stock Split History for Bank of New York Company

Date Type
08/13/1998 2 For 1 Stock Split
08/08/1996 2 For 1 Stock Split
05/13/1994 2 For 1 Stock Split
11/07/1986 3 For 2 Stock Split
10/07/1983 2 For 1 Stock Split

Stock Split History for Wind River Company

Declared Record Payable Type
01/07/99 01/19/99 02/04/99 3 For 2 Stock Split
02/14/97 02/24/97 03/10/97 3 For 2 Stock Split
04/26/96 05/10/96 05/24/96 3 For 2 Stock Split

Difference between stock splits and stock dividends

The laws of logics tells that stock splits and stock dividends can leave the value of the firm unaffected, increase its value, or decrease its value. The issues are complex enough that one cannot easily determine which of the three relationship holds. Stock splits and stock dividends are similar in several aspects. In particular, they are both corporate events in which each shareholder receives a certain number of new shares free of charge whereby the stock price is reduced accordingly. However, there are also some differences between the two events. In the case of a stock split, each old share is split into a number of new shares with a reduced par value, leaving the total equity capital unchanged. In the case of a stock dividend, a number of new shares is received for each share owned. The new shares have the same par value as the old shares, whereby the total equity capital increases proportionally with the size of the stock dividend.1 It is well documented that, on average, the announcement of a stock split or a stock dividend is associated with a positive stock market reaction. Still, very little is known about the exact explanation for the positive announcement effect and only a few papers have taken the difference between stock splits and stock dividends into account when examining the announcement effect.

Advantages for Investors

There are plenty of arguments over whether a stock split is an advantage or disadvantage to investors. Someone would say that a stock split is a good buying indicator, letting us know 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. Despite this fact the investment newsletter business has taken note of the often positive sentiment surrounding a stock split. There are entire publications devoted to tracking stocks that split and attempting to profit from the optimistic nature of the splits. Critics would say that this strategy is by no means a time-tested one and questionably successful at best. Factoring in Commissions also take part when we discuss about advantages and disadvantages of stock splits.

Historically, buying before the split was a good strategy because of commissions that were weighted by the number of shares you bought. It 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 10 shares or 1,000 shares. Some online brokers have a limit of 2,000 or 5,000 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 if you buy pre-split or post-split. Stock's price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased. In the example of a 2-for-1 split, the share price will be halved. Thus, although the number of outstanding shares and the stock price change, the market capitalization remains constant.

Stock Splits Calendar

The stock split is not an enough indicator that the company is worth of investing in. Further research should be done to see whether it is really reasonable to put your money there. Still, if stock splits are what you are looking for, there are many sources (such as yahoo stock split calendar) that will provide you with information on future stock splits, which may be a good starting point for your research.

Company Ticker Split An- Date Ex- Date # of Prior Splits Price Month Prior to An- Date Price Prior to An- Date An- Date Price Pay Date Price
RITCHIE BROS. AUCTIONEERS, INC. RBA 3:1 FEB 21 APR 28 1 72.31 77.26 73.25 88.42
CHINDEX INTERNATIONAL INC. CHDX 3:2 MAR 18 APR 17 4 41.68 34.33 33.40 41.00
HOLOGIC, INC. HOLX 2:1 JAN 30 APR 03 2 68.64 61.80 64.36 58.99
GFI GROUP, INC. GFIG 4:1 FEB 21 APR 01 0 78.75 87.75 83.14 57.30

Conclusion

Stock splits have historically been used by the companies to increase or lower the number of outstanding shares and to change their company’s negative impressions of the stock price. Investment timing in companies like these has shown to be more psychological than realistic since stock prices are only adjusted in a way that the market capitalization remains constant. Stock splits are another interesting feature of investing and a good piece of knowledge for those who are learning about the stock market. The most important thing to know about stock splits is that there is no effect on the worth (as measured by market capitalization) of the company. A stock split should not be the deciding factor that would attract you into buying a stock. While there are some psychological reasons why companies will split their stock, the split doesn't change any of the business fundamentals. In the end, whether you have two $50 bills or one $100 bill, you have the same amount in the bank as far as the stock split is concerned.

Works Cited

"Stock Splits." U.S. Security and Exchange Commission. Nov. 2000
<http://www.sec.gov/answers/stocksplit.htm>.

Bechmann, Ken and Raablle, Johannes. Differences between Stock Splits and Stock Dividends. March 10, 2004.

"Stock Splits." Rightline Staff Writers. Aug. 2007
<http://www.rightline.net/splits/>.

Ross, Westerfield, and Jordan, Essential of Corporate Finance, 6th ed.New York: McGraw-Hill/Irwin, 2008. pg. 448-449

"Stock Split and Stock Dividends." Accounting Coach. Feb. 2008
<http://www.accountingcoach.com/online-accounting-course/17Xpg05.html>.

"Stock Splits Calendar." Stock Splits Apr. 2008
<http://www.stocksplits.net/1splits.htm>.

"Stock Splits History." Wind River.
<http://ir.windriver.com/phoenix.zhtml?c=91814&p=irol-dividends >.

"Reverse Stock Splits." U.S. Security and Exchange Commission. Nov. 2000 <http://www.sec.gov/answers/reversesplit.htm>.