Definition of Stock Split
A stock split usually refers to a corporation dividing its existing number of shares of common stock into a greater number of shares. For instance, a corporation with 100,000 shares of stock before a 2-for-1 stock split will have 200,000 shares after the split. An investor owning 100 shares before the stock is split 2-for-1 will have 200 shares after the split.
Stock Price After a Stock Split
Since the corporation is not changed (total assets, liabilities, stockholders’ equity remain the same) by the stock split, the change in the number of shares will cause a change in the market price of each share. For example, if a share had been trading at $50 before a 2-for-1 stock split, a share should be trading at $25 after the stock split.
If the corporation had 100,000 shares of common stock trading at $50 per share before a 2-for-1 stock split, the total market value of the shares would have been $5 million. After the 2-for-1 stock split, the corporation’s market value will also be $5 million (200,000 shares X $25 per share). This is the same for each investor. For example, the 10 shares owned by a small investor had a market value of $500 (10 shares X $50). After the 2-for-1 stock split, the small investor shares will also have a market value of $500 (20 shares X $25).
Why Stock Splits Occur
Stock splits such as 2-for-1, 3-for-2, 4-for-1, etc. (which increase the number of shares) are intended to decrease the market price of each share of a corporation’s common stock. Often the purpose is to allow small investors to purchase 100 shares of the corporation’s stock at a more reasonable total cost.
Reverse stock splits such as 1-for-10 (which decrease the number of shares) are intended to increase the market price of each share of stock. Usually the purpose is to minimize the number of small investors. To illustrate, assume that a corporation had 800,000 shares of stock that were trading at $2 per share (resulting in a total market value of $1.6 million). After a 1-for-10 reverse stock split, there will be only 80,000 shares trading at $20 per share (which also results in a total market value of $1.6 million). Prior to the reverse stock split, small investors were able to purchase 100 shares for just $200. After the stock split, an investor will need $2,000 (100 shares X $20) to purchase 100 shares.
