Many say that a company's stock price is a clear signal of market expectations about its performance. In contrast, some academics claim that stock prices fluctuate more than changes in shareholder expectations can justify. Consequently, the market can push some stock prices to an unreasonably high and unsustainable level.
Worldly wisdom may respond by saying that when stocks become so expensive as to be inaccessible to many, a stock split might be in order. This is particularly true when one company's stock rises, say, 50 percent while the overall market goes up by only 20 percent.
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What Is a Stock Split?
A stock split is one of the common corporate actions that occur when a company multiplies the number of its outstanding stock shares by "splitting" its existing shares into additional shares according to a ratio of the number of future shares to the current number of shares, such as 3-to-1. The process is undertaken to increase the stock's liquidity by lowering its price point to one that a larger number of people will be amenable to pay.
While the number of shares outstanding increases in a ratio of 2-to-1 or 3-to-1 or more, the dollar value of the shares outstanding, or the company's market capitalization, remains unchanged. In effect, the stock split adds no real value. A company's board of directors determines the stock split that will occur: 2-for-1 stock split, 3-for-1 stock split, 5-for-1 stock split, 10-for-1 stock split or more.
Benefits of Stock Split
The thinking behind a stock split is that if a stock price is very high, relatively few investors will be interested in buying a standard board lot of 100 shares. Other investors may be more likely to purchase 30 shares of stock at a market price of $50 per share than buy 10 shares with a price of $150 per share.
Also, the increase in the shares from say 10,000 shares to 30,000 shares following a 3-for-1 stock split, for example, leads to the stock's greater liquidity due in part to a narrow bid-ask spread. In turn, the liquidity means trades impact the share price less than would otherwise be the case. What's more, a split spurs interest in the stock of some investors to the point that they may buy the stock at a higher price than they might otherwise pay.
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Common Stock Split Ratios
The 2-for-1 and 3-for-1 – 2:1 and 3:1 – stock splits are the more common stock split ratios. The first ratio indicates that the shareholder will receive one new share for each share she owns before the split. When the 3-for-1 stock split occurs, a shareholder will receive two additional shares for each share she owns.
While the number of shares outstanding increases by a certain multiple, in no case does the stock split add real value. The company's market capitalization – the total number of outstanding shares multiplied by the price per share – remains the same. Also, the dollar value of the investor's total number of shares at the time of the split is the same as the pre-split value.
Example of Market Capitalization
In August 2020, Apple shares underwent a 4-for-1 stock split. Prior to the split, an Apple share traded at about $540. Following the split, the share price was $135, or $540 per share divided by four equals $135.
At the time of the stock split, existing shareholders received an additional four shares for each share they owned. At that time, an investor who owned 500 pre-split shares acquired an additional 3,500 shares, which meant she owned 4,000 shares following the stock split. Although this split increased shares from about 3.4 billion shares to 13.6 billion, Apple's market cap remained about the same: $2 trillion.
Post Stock Split Market Response
The practical effect of a stock split is that post-stock split, each share will be within the budget of a larger percentage of those who buy stocks. As with any market that attracts additional buyers, more shares might be sold and the increase in demand will be reflected in the rise in the share price.