A stock split, also called a stock divide or a share split, occurs when the number of shares outstanding in a company is increased. The market capitalization of the company remains the same, but dilution does not occur.
In a 3-for-1 stock split, for example, existing shareholders are given three shares for each one they own. If a company has 5 million shares and undergoes a 3-for-1 stock split, it will subsequently have 15 million shares.
As the market cap of the company stays the same, each share goes down in value proportionally to the increase in shares outstanding. So, in a 3-for-1 stock split, if each share had a value of $9, after the split they will be worth $3.
After a stock split, each share is worth less, but shareholders end up with the same amount.
Dilution does not occur, because each shareholder still owns the same total value. If a stockholder had 3 shares worth $9 each (total value $27), after the number of shares outstanding tripled, he or she would have 9 shares worth $3 each, which is still a total of $27.
In June 2014, American multinational technology company Apple Inc. underwent a 7-for-1 stock split, which reduced the value of each share from $645 to $94. Jesse Solomon wrote in CNN Money that 220 responses were received from readers, with the vast majority keen about either buying shares for the first time or adding to their stake.
Why decide to do a stock split?
Stock splits usually occur after the value of a company’s share increased significantly. The board of directors may decide that their shares are too expensive for many investors. Fewer people can afford a $220 share than one costing $40.
Some people say that stock splits help boost share prices. If more people can afford to buy it, then demand will be higher. However, studies have not been able to support this theory.
According to Principal Financial Group, small investors typically buy shares in round lots – one hundred shares or multiples of 100. Most splits aim to keep stock prices within the $30 to $50 range, which allows small investors to still buy a round for $5,000 or less.
Companies like having a broad shareholder base, with investors coming from the local community and across the country. As shares become more expensive, the shareholder base tends to narrow. A wide shareholder base helps prevent small groups of stockholders from gaining too much control.
Most investors believe they are getting more for their money after a stock split. The move also means a company is doing well – if the split occurred because share the price rose significantly, which is usually the case.
Beware of companies that undergo a series of stock splits within a short period. This could mean their growth spurt is coming to an end.
Why does Warren Buffet resist stock splits?
Some companies let their share values continue increasing and refuse to stock split. The American multinational conglomerate holding company Berkshire Hathaway, which is controlled by multibillionaire investor Warren Buffett, has super expensive shares – on July 20th, 2015, they were worth $ 217,006.55 each.
This exceptionally high price prevents about 99% of all investors ever considering purchasing shares in Berkshire Hathaway. So, why would Mr. Buffett, an investment genius, choose to price his company out of the market?
Berkshire Hathaway shares are the most expensive in the world. (Image: liveauctiongroup.net)
While a stock split does open up a company to a wider shareholder base, which means greater volume, it also brings considerably more volatility. While lower share prices might attract smaller investors, they are also more likely to abandon ship during tough times.
By keeping his company’s share price super high, Mr. Buffet makes sure his investors are the types who will hold onto their stock for many years, or even decades. In short, he believes that expensive shares attract long-term investors and give his company stability.
Video – What is a stock split?
This video, by livemint.com, gives examples of stock splits and explains what happens.