Stock splits

Definition

A stock split is a corporate action that increases the number of outstanding shares by converting existing shares into multiple new shares, while maintaining the overall value of the equity. This process helps to lower the trading price of each share, making it more affordable for investors, and is often seen as a sign of confidence from a company when its share price rises significantly.

5 Must Know Facts For Your Next Test

1. In a stock split, if a company declares a 2-for-1 split, each shareholder will receive an additional share for every share they own, effectively doubling the number of shares but halving the stock price.
2. Stock splits do not change the total market capitalization of the company since the overall value remains the same after adjusting for the split.
3. Companies often initiate stock splits when their share price becomes too high for smaller investors, making it more accessible to a broader audience.
4. The split ratio can vary; common ratios include 2-for-1 or 3-for-1 splits, but companies can choose any ratio that suits their objectives.
5. After a stock split, it's crucial for investors to understand that while the number of shares increases and the price decreases, their ownership percentage and total investment value remain unchanged.

Review Questions

• How does a stock split impact the financial statements of a company and its shareholders?
  • A stock split primarily affects the equity section of a company's balance sheet by increasing the number of outstanding shares while reducing the par value per share. However, it does not impact total equity or assets. For shareholders, although they will have more shares after a split, the value of their total investment remains unchanged since the share price adjusts accordingly. This means that financial ratios like earnings per share (EPS) must be recalculated to reflect the increased number of shares.
• Discuss how stock splits can influence investor perception and market behavior in relation to earnings per share (EPS).
  • Stock splits can create a positive perception among investors as they often signal strong company performance and growth potential. This positive sentiment can lead to increased buying activity, driving up demand for shares. However, since EPS is calculated based on the total number of outstanding shares, a stock split will typically result in a lower EPS figure post-split. Investors must understand that this decrease in EPS does not indicate reduced profitability but rather reflects an increase in share count.
• Evaluate how a company’s decision to implement a stock split could affect its market capitalization and future capital-raising efforts.
  • When a company opts for a stock split, its market capitalization remains unchanged immediately following the action; however, it may influence future growth and investor interest. A lower share price resulting from a stock split can attract new investors who may have previously viewed the stock as too expensive. This increased interest may enhance liquidity and potentially raise market capitalization over time. Moreover, companies looking to raise capital might find it easier to issue additional shares at an attractive price following positive investor response to a split.

Related terms

stock dividends: Stock dividends are additional shares given to shareholders, usually at a specified ratio, instead of cash, which can affect the share price and total equity.

earnings per share (EPS): Earnings per share (EPS) is a financial metric calculated by dividing net income by the number of outstanding shares, used to measure a company's profitability on a per-share basis.

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