What is a Stock Split and How Does it Work?

A stock split is what happens when a company takes 100 shares and turn them into 500. They do this for all the outstanding shares. Multiples vary. (The most common stock splits are 2-for-1 and 3-for-1.) Investors owns more shares, but the price is cheaper. Your account balance remains unchanged during a split. It won’t go up or down until the stock starts trading again.

Companies do a stock split when their share price is too high and they want to encourage investment by people with less cash, and/or increase liquidity.

For example, let’s say you’re 18 and just opened your first brokerage account. You want to buy shares in Super Omega Corp (SOC) because they make your favorite video game. You only have $500 to invest, but when you go to buy shares of $SOC, you discover that the stock trades for $12,390.

It turns out that SOC has been around for 70 years. Prior to video games they made consumer electronics, furniture, and various paper products. But now all they make is first-person shooters and gothic horror roleplaying games.

Some brokerages allow you to buy fractional shares, but most do not. If SOC wanted small investors like you to be able to buy into the company, they would have to do a 25 for 1 stock split. This would change the price from $12,390 to $495.60. Now you can buy a single share. Go, you.

It’s important to note that nothing has fundamentally changed about the company. Its market capitalization is the same as it was yesterday. It was worth $80 billion before the split, and it’s still worth $80 billion after the split. All that’s changed in the share price and the number of outstanding shares. Although now the spread between the bid and the ask is probably smaller.

Remember earlier when I mentioned liquidity? An object’s liquidity is how easy it can be converted into cash. For example, gold bars have higher liquidity than antique furniture because they’re easier to sell.

A stock’s liquidity is based on its share price and volume. Some stocks, like Warren Buffet’s Berkshire Hathaway-A shares only trade about 50 shares a day. That’s because the stock has never split and trades for $477,527. The spread between the bid and the ask is more than $400. This is not a very liquid stock because it’s expensive to buy or sell large quantities of it in a hurry. (Imagine how hosed you would get on the price if you tried to sell antique furniture in a hurry!)

Cheaper stocks tend to have lower spreads. For example, the spread between the bid and the ask for a share of Apple is 1 cent. Percentage wise, if you’re buying or selling at market, you’ll pay 14x more to trade Berkshire Hathaway than Apple.

As a CEO, you never want to discourage investment in your company for a dumb reason like “The stock price is too high.” While CEOs might say they care about the stock price, what they really mean is they care about the market cap. The higher the market cap, the easier it is to raise money by issuing shares or debt. So, it’s important that people keep investing in your company. Cash fuels investment and investment fuels growth. Growth leads to more revenue, and everybody loves Raymond revenue.

A stock split will not impact your taxes. You’ve haven’t bought or sold anything. Your position hasn’t changed. You just own more pieces of the pie, except the pieces are proportionally smaller.

Companies that do a stock split are usually ones that are growing. It’s not uncommon to see a company do multiple stock splits over time. Wal-Mart has done nine 2-1 stock splits since 1975. As of today, a single share of Wal-Mart trades for $143. This is a reasonable price for small investors to buy in at.  If Wal-Mart had never done a single stock split, the share price would be $73,216. Most people couldn’t buy a single share!

So, if you came to this article wondering whether a stock split is good or bad, I hope you have concluded that a stock split is good. Stocks that split will often continue to rise and might even split again in the future.

Understanding stock splits is important to understanding a reverse stock split. (Sometimes they’re good, sometimes they’re bad.)

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