Stock splits

Definition

A stock split is a corporate action that increases the number of shares outstanding while proportionately reducing the par value and market price per share. This action is often taken to make shares more affordable for investors and enhance liquidity, but it does not change the overall market capitalization of the company or the total value held by shareholders. Understanding stock splits is crucial for calculating both basic and diluted earnings per share, as they affect the number of shares considered in these computations.

5 Must Know Facts For Your Next Test

1. In a stock split, if a company executes a 2-for-1 split, shareholders will receive an additional share for every share they own, effectively doubling the number of shares while halving the price per share.
2. Stock splits are typically viewed positively by the market, as they can make shares more accessible to a broader range of investors and potentially boost trading volume.
3. When calculating earnings per share after a stock split, the number of shares used in the calculation must be adjusted to reflect the increased number of shares outstanding.
4. Stock splits do not affect a company's fundamental value; they simply change the price and quantity of shares in circulation without impacting total equity.
5. Companies may choose to execute a stock split if their share price has risen significantly, making it seem overly expensive for potential investors, which can hinder liquidity.

Review Questions

• How does a stock split impact the calculation of basic and diluted earnings per share?
  • A stock split affects the calculation of basic and diluted earnings per share by increasing the number of shares outstanding. For example, if a company conducts a 2-for-1 stock split, it doubles the number of shares considered in EPS calculations. This means that when calculating both basic and diluted EPS, analysts must adjust the number of shares to ensure accurate reporting post-split, allowing for a fair comparison with prior periods.
• Discuss how stock splits can influence investor perception and market behavior.
  • Stock splits can influence investor perception by creating a sense of affordability and accessibility around a company's shares. When a company's stock price becomes lower due to a split, it may attract retail investors who previously found it too expensive. This can lead to increased trading activity and potentially boost market liquidity. Furthermore, companies often announce splits in conjunction with positive financial performance, reinforcing investor confidence and attracting more buyers.
• Evaluate the implications of stock splits on shareholder value and capital structure over time.
  • While stock splits do not directly alter shareholder value or capital structure, they can have significant long-term implications. By increasing liquidity and making shares more accessible, companies may see heightened investor interest, which could drive up share prices over time. However, if a company frequently engages in stock splits without corresponding growth in fundamental business performance, it may lead investors to question management strategies. Thus, while the immediate effects are neutral regarding value, perceptions formed around splits can shape future capital structure decisions and market behavior.

Related terms

earnings per share (EPS): A financial metric that indicates the amount of profit allocated to each outstanding share of a company's stock, calculated by dividing net income by the number of shares outstanding.

dilution: The reduction in existing shareholders' ownership percentage due to the issuance of new shares, which can occur in situations like stock splits or when options and convertible securities are exercised.

market capitalization: The total market value of a company's outstanding shares, calculated by multiplying the current share price by the total number of outstanding shares.