A stock split is an action by a publicly traded company that has the effect of increasing the number of shares outstanding on the market. For example, in a two-for-one stock split, a company with ten million shares outstanding will split each share in half, so that there will be 20 million shares. When a stock split occurs, the price of a stock is cut proportionally. Again, using the two-for-one example, a stock that is worth $50 U.S. Dollars (USD) before the split will be worth $25 USD per share after.
When a company is planning a stock split, the action must be approved by the company’s board of directors, as well as its major shareholders, if it is to occur. Although a company may choose to split its stock when its price is rising, the actual split as such does not affect the market capitalization or value of the company. A company’s market capitalization is equal to the number of existing shares, multiplied by the share price. When the number of shares doubles, the price of one share is also cut in half, so there is a net zero effect on total value.
One common reason to initiate a stock split is to make a firm’s stock more accessible to smaller investors, thereby possibly creating greater demand for the stock, and increasing its price. If one share of XYZ stock is valued at $500 USD, an individual investor would have to pay $5,000 USD for 100 shares. This will likely be a significant portion of one investor’s portfolio, and may keep him from purchasing the stock, even if he believes that the company is a fundamentally good investment. On the other hand, if one share of XYZ is priced at $25 USD, and the company’s fundamentals are the same, the investment will look much more attractive to individuals, whose funds are limited.
A stock split can signal, in some cases, that a company is implicitly confident in its economic future. If this is generally perceived to be the case, this fact alone will increase the market value of the stock. Some companies avoid stock splits as a rule, and have never had one. Berkshire Hathaway, for example, is a publicly traded company whose class A shares have at times sold for well over $100,000 USD. This high share price has reduced the liquidity of the stock, as well as having achieved its intended effect, namely that of attracting long-term investors rather than short-term speculators.