If one is served one slice of a pie that's divided into 10 pieces, the pie is no less flavorful than a five-slice pie, but the value of each slice, in terms of dollars and cents, is likely to be less. The primary benefit of the 10-slice pie is that it serves 10 people, rather than just five.
The phenomenon is not unlike what happens following a stock split, be it a two-for-one, three-for-one (also known as a 3:1 split) or five-for-one split. The only immediate meaningful effects in financial terms are a stock's cost basis and the company's market capitalization after the stock split.
What Is a Stock Split?
A stock split occurs when a company divides each one of its existing shares of stock into multiple shares. A company implements a stock split to increase the stock's liquidity.
While following a stock split the number of shares outstanding – the number of shares on the open marker – increases by a specific multiple, the dollar value of the total number of shares is the same as that of the number of shares outstanding prior to the split. Consequently, from the company's perspective, a stock split, like a stock dividend, is a non-monetary transaction.
Two common split ratios are 2-for-1 and 3-for-1, or 2:1 or 3:1 stock split. In the case of a 2:1 split, for each share that a stockholder owns prior to a stock split, she will own two shares following the split. In a similar fashion, should a 3:1 stock split occur, a stockholder will receive an additional two shares for each share he owned prior to the split.
Purpose of a Stock Split
A corporation implements a stock split to divide each existing share into multiple shares. By multiplying the number of outstanding shares, the company takes administrative action to decrease by a significant percent the per-share price of the stock outstanding.
As the result of a stock split, the stock becomes more actively traded in that its share price is sufficiently low as to not preclude its purchase by a larger number of investors. As a result, the split increases the liquidity of its shares.
Long-Term Effect of a Stock Split
The fact that some people prefer to purchase bargains is one reason that a stock that undergoes a split may experience a rise in price immediately after the split. Perhaps it's less gut-smacking to purchase 50 shares of stock with a $100 price per share than buying 10 shares of stock at $500 per share.
When a company is profitable, one that generates a healthy revenue stream and one whose management has the approval of "the market," it's likely that the stock will gain additional value over the long term. Following a split, an investor has a greater opportunity to capture more "share upside" than before the split, when the per-share price is high.
Following a stock split, the price per share adjusts according to supply and demand.
A shareholder does not recognize a gain or loss due to a stock split, so it's not a tax-relevant event. Instead, the gain or loss is recognized at the time you sell the stock. To calculate that event correctly, you must calculate the per-share basis following the stock split.
To begin, divide the price you paid for the relevant shares by the number of shares that you purchased. For instance, assume that you paid $8,000 to acquire 10 shares. In this case, the per-share basis equals $8,000 divided by 10, or $800.
Next, divide the per-share basis by the number of shares that you received following the stock split for each share that you had owned prior to the split. For instance, after a 3:1 stock split, the new per-share basis equals $800 divided by 3, or a per-share basis of $266.67.
You repeat these two steps for any subsequent stock split.
Market Capitalization After Stock Split
A company's market capitalization, or market cap, is the total market value of its outstanding shares of stock. You calculate the figure by multiplying the total number of shares outstanding by the stock's per-share price. For instance, for a corporation that has 10 million shares outstanding and the current per-share price is $50, the company's market capitalization is $500 million.