What Happens When Companies Split Stock?

What does splitting stock mean for a company or business?

Investors are always eager to cash in on the latest trends in the stock market in order to increase the value of their portfolios, no matter what the consequences may be. Companies that go public seem to attract a lot of investor attention, as in the case of initial public offerings. Some investors have their eyes out on announcements of impending stock splits. As with all speculative investments, stock splits may temporarily increase net worth, but may be a risky investment depending on market conditions.

Stock splits are a marketing incentive offered by companies looking to attract new investors. When companies perform well and meet earnings expectations, they will look to make additional shares available to investors if demand for the stock exceeds the current supplies available. A split in this sense would allow additional investors to take advantage of and invest in the company. Stock splits are also initiated when companies think that the price of stock shares is too prohibitive for the average investors and so decide to reduce the price per share by increasing the number of shares available. Many investors are under the illusion that if a company splits a stock that it's a definite upswing in the company's fortunes.

When a stock is split, the number of shares owned by an investor will increase, but the relative value of the stock remains the same. The price per share is distributed relative to the way the stocks are split. Stocks are split in a number of ways. The most familiar to stockholders is the 2-for-1 split, in which 2 shares are given for each share owned. This is also known as a 100% stock split. If each share price was $100 prior to the split, then the price after a 2-for-1 split is $50 per share for a grand total of $100; thus, the relative value remains the same. Another common split pattern is the 3-for-2 split, or the 50% split. For every share of stock that owned, the shareholder receives one and a half shares. Again, the price for every share is lowered as the number of shares increases, but the relative value of all shares owned remains the same. No additional value or wealth is gained unless the per share price trades higher after the split.

There can be the opposite condition in which a stock price is so low that the perceived value of the company can be in jeopardy, as in the case of penny stocks. In these situations, a reverse split may occur. While not technically a "split", a reverse split occurs when a company wishes to raise the value of a stock by pooling shares together to raise the price per share. Instead of having 1000 shares of a stock valued at $5 per share, the number of shares is reduced to perhaps 500 shares trading at $10 per share. The price per share increases while the overall number of shares available decreases. For example, a 1-for-2 split takes 2 shares that the shareholder owns and combines it into a single share. Again, the overall value relative to the portfolio doesn't change, but the number of shares owned changes.

Stock splits are carefully executed and not a spur of the moment decision. Companies are required to announce a stock split before it takes place. Before the actual stock split, though, speculation about a company's future can drive the price of the stock up drastically. In some instances, investors may be able to buy into the stock before the stock split occurs. Websites such as www.stocksplits.net will generally provide announcements of any impending stock splits.

The process by which a stock split is announced is multi-tiered. The first stage of a stock split is the preannouncement period. This stage can last as long as 60 days and is announced in publications such as RightLine or on websites such as www.stocksplits.net. The second stage of a stock split is the formal announcement. After the announcement, there is a leveling off of public interest, called the dormancy period. After the dormancy period, there is a pre-split run in which investors may purchase the stock prior to the split date. At split execution, investors who have not purchased stock previous to the split will have to pay the post-split price per share. Finally, there is a post-split depression period in which interest in the stock declines, as well as any inflated price gains obtained from the speculation period should the stock price decrease.

Common stock splits can therefore increase the number of shares without increasing the price per share. As the price per share of the stock is lowered, investors are attracted to make the plunge because of the speculation that the values will go up. Initially, investors buy into the stock, causing a jump in the individual share price. This is called the split effect. Once the novelty of investor speculation decreases, the post-split depression takes place, and prices level off.

As with any large investment, careful research should be an investor's initiative prior to the actual purchase.

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