Many investors get excited when a company issues a stock split. What is a stock split? Is it good or bad? How does it affect your investment? Let’s take a look at how a stock split works and what is in it for you!
What is a stock split?
A stock split is when a company changes the number of shares outstanding. At the same time they adjust the price of the shares to offset the change.
What kind of stock splits are there?
A common split is 2:1, however, there can be 3:2, 3:1 and many other combinations. They can also reverse split, in a 1:2 for example.
What does it do to the value of your investment?
Nothing. If a stock you own is trading at $20 per share and splits 2:1, the price will be $10 for each share. If you owned 50 shares, you will now own 100 shares. Your investment is worth $1,000 both before and after the split.
How does a split affect the cost basis?
In the example above you had 50 shares at $20 each; let’s say the purchase price was $15. When the stock splits, you have 100 shares at $10 each and the cost basis adjusts to $7.50 per share. No matter what happens to the share price or stock splits, your total investment will always be $750 (assuming no dividend reinvestments or commissions).
Why do companies issue splits if you still have the same amount of money?
While the value remains the same for each investor, there’s a certain amount of playing to people’s connotations of the new price that companies have found valuable.
- Psychology of lower price. While it is unrelated to the performance of a stock, people look at a lower price of a stock as favorable. Investors may believe that after a stock splits, it will return to the pre-split price.
- Psychology of more shares. When investors “double” the number of shares they own, they are likely to pass on positive vibes. This can create buzz. In addition, if the pre-split price was an all-time high, there was likely a lot of positive vibes already out that the company was doing well.
- Liquidity. Lower prices often result in more activity. Companies like the increased liquidity because more people are able to buy and sell the stock.
What if you buy a stock after the record date for the split?
As long as you buy the stock before the date the split takes place, your stock will split too. The record date does not have an impact on your split.
Do all companies issue splits?
No. A good example is Berkshire Hathaway which was trading at $132,000 yesterday.
Article featured in: Carnival of Personal Finance.