Understanding Stock SplitsPosted: Feb 26, 2010 Say you had a $100 bill and someone offered you

two $50 bills for it. Would you take the offer? This might sound like a pointless question, but the action of a stock split puts you in a similar position. In this article we will explore what a stock split is, why it's done and what it means to the investor.

What Is a Stock Split? A stock split is a corporate action that increases the number of the corporation 's outstanding shares by dividing each share, which in turn diminishes its price. The stock's market capitalization, however, remains t he same, just like the value of the $100 bill does not change if it is exchanged for two $50s. For example, with a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share is reduced by half: two shares now equal the original value of one share before the split. Let's say stock A is trading at $40 and has 10 million shares issued, which give s it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to implement a 2-for-1 stock split. Fo r each share shareholders currently own, they receive one share, deposited directly into their brokerage account. They now have two shares for each one previously held, but the price of the stock is split by 50%, from $40 to $20. Notice that the market capitalization stays th e same - it has doubled the amount of stocks outstanding to 20 million while simultaneously reducing the stock price by 50% to $20 for a capitalization of $400 million. The true value of the company hasn't changed one bit. The most common stock splits are, 2-for-1, 3-for-2 and 3-for-1. An easy way to d etermine the new stock price is to divide the previous stock price by the split ratio. In the case of our example, divide $40 by 2 and we get the new trading price of $20. If a stock were to split 3-for-2, we'd do the same thing: 40/(3/2) = 40/1.5 = $26.6. It is also possible to have a reverse stock split: a 1-for-10 means that for eve ry ten shares you own, you get one share. Below we illustrate exactly what happens with the most popular splits in regards to numbe r of shares, share price and market cap of the company splitting its shares.

What's the Point of a Stock Split? So, if the value of the stock doesn't change, what motivates a company to split its stock? Good question. There are several reasons companies consider carrying out this corporate action. The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brin gs the share price down to a more "attractive" level. The effect here is purely psychological. The actual value of the stock doesn't c hange one bit, but the lower stock price may affect the

way the stock ck also gives they suddenly s rises, they

is perceived and therefore entice new investors. Splitting the sto existing shareholders the feeling that have more shares than they did before, and of course, if the price have more stock to trade.

Another reason, and arguably a more logical one, for splitting a stock is to inc rease a stock's liquidity, which increases with the stock's number of outstanding shares. You see, when stocks get into the hundreds of dollars per share, very large bid/ask spreads can result (see Why the Bid/Ask Spread Is So Important.). A perfect example is Warre n Buffett's Berkshire Hathaway, which has never had a stock split. At times, Berkshire stock has traded at nearly $100,000 and its bid /ask spread can often be over $1,000. By splitting shares a lower bid/ask spread is often achieved, thereby increasing liquidity. None of these reasons or potential effects that we've mentioned agree with finan cial theory, however. If you ask a finance professor, he or she will likely tell you that splits are totally irrelevant - yet companies s till do it. Splits are a good demonstration of how the actions of companies and the behaviors of investors do not always fall into line with financial theory. This very fact has opened up a wide and relatively new area of financial study called behavioral finance (see T aking A Chance On Behavorial Finance.).

Advantages for Investors There are plenty of arguments over whether a stock split is an advantage or disa dvantage to investors. One side says a stock split is a good buying indicator, signaling that the company's share price is increasing an d therefore doing very well. This may be true, but on the other hand, you can't get around the fact that a stock split has no affect on th e fundamental value of the stock and therefore poses no real advantage to investors. Despite this fact the investment newsletter busines s has taken note of the often positive sentiment surrounding a stock split. There are entire publications devoted to tracking sto cks that split and attempting to profit from the bullish nature of the splits. Critics would say that this strategy is by no means a time -tested one and questionably successful at best.

Factoring in Commissions Historically, buying before the split was a good strategy because of commissions that were weighted by the number of shares you bought. It was advantageous only because it saved you money on commissions. This isn't s uch an advantage today because most brokers offer a flat fee for commissions, so you pay the same amount whether you buy 10 shares or 1,0 00 shares. Some online brokers have a limit of 2,000 or 5,000 shares for that flat rate, but most investors don't buy that many shares a t once. The flat rate therefore covers most trades, so it does not matter if you buy pre-split or post-split.

Conclusion The most important thing to know about stock splits is that there is no effect o n the worth (as measured by market capitalization) of the company. A stock split should not be the deciding factor that entices you in to buying a stock. While there are some psychological

reasons why companies will split their stock, the split doesn't change any of th e business fundamentals. In the end, whether you have two $50 bills or one $100 bill, you have the same amount in the bank. http://www.investopedia.com/articles/01/072501.asp#axzz1YI1ORExQ