Let’s say a company is worth $1 million dollars, and it is owned by 4 people equally, each of whom have 1 share of the company’s stock. So each person has 1 share, worth $250,000.

The company announces a 2 for 1 stock split.

The thing to remember is, a stock split is an increase in shares that matches a decrease in price, so the company has the same overall value and the shareholder’s wealth isn’t changed.

So if the company does a 2 for 1 stock split, they are replacing each prior 1 share of the stock with 2 shares, but the value of each share is divided by 2.

Now each of those 4 people would have their prior 1 share of stock replaced with 2 shares of stock, but each share of stock would go from being worth $250,000 to being worth $125,000.

Notice that the value of the total shares of the company is still $1,000,000, and each shareholder still has $250,000 worth of stock. It’s just that now they have twice the number of shares, worth half as much.

The company could have chosen to have a 3 for 1 stock split, or a 5 for 1 stock split. Whatever ratio they choose, since it gets applied both to the number of shares, and to the price, the total value of the company and the shareholder’s wealth doesn’t change.

A stock split is a lot like a chef cutting up a pie into more pieces, but making sure each person who gets a slice gets the same amount of pie they had before. In fact, if a company has options or warrants outstanding, they are also adjusted for the stock split, so that their value remains unchanged.

A stock split is also sometimes called a stock divide.

Definitions

A stock split is an increase in the number of shares in a company, and a decrease in the price per share, which matches so that the market capitalization of the company remains the same.

Commentary

Markets can be more complicated than simple math. A stock split has certain advantages and disadvantages.

Here are some advantages of a stock split:

1. Affordability of Each Share Is Improved: Each share of the stock now has half the value it did before. Someone who would not buy a stock share that costs $250,000 might buy a stock share that costs $125,000. And so on. So the universe of potential buyers of a share of stock may increase if the price of each share is lowered through a stock split.

2. More Shares Are Available So You Can Have a Wider Ownership Base: Literally the more a stock has been split, the larger the quantity of individual shares that exist. This potentially allows a wider number of people to own the shares. This has second order consequences, such as the more people who own your stock, the more a company can potentially be protected from government regulations. (In the Robber Baron days, some companies would split their stock so as to sell it to politicians and judges, in order to provide them political and regulatory advantages or protection. Nowadays we refer to this particular form of ownership as corruption.)

3. Investor Expectations of Price Ranges: Investors are often puzzled by the cost of each share of a stock that hasn’t been split, because the significant majority of companies do split their shares if their value goes over $200 per share or so. By splitting its stock a company can avoid this confusion.

4. Certain Investors Prefer Stocks that Keep Splitting: Since very successful companies (Intel, Microsoft, etc) generally keep splitting their stock every few years during their rapid growth phase, there is an aura of vitality around a company that needs to keep splitting its stock to keep it in the $5 to $200 range per share. Some investors incorrectly conclude that the frequency of stock splits speaks to a company’s future prospects.

5. Splitting It Yourself Helps You Avoid Having Other People Split Your Stock For You: If a company chooses not to split its stock, other people can create a business whereby they sell shares of their entity that owns shares of the stock that won’t split. Warren Buffett ran into this issue when unit investment trust companies were potentially going to be created to let people own fractional parts of Berkshire Hathaway’s stock which was very expensive per share. Partly in order to avoid this problem, he had the company issue B shares at 1/16th of the value of the A shares.

Here are some disadvantages of a stock split:

1. People Sell Shares More Carelessly if Each Share Costs Less: Warren Buffett’s Berkshire Hathaway historically did not split stock, in part because Mr. Buffett wants investors who think of themselves as being in partnership with him. In essence, if a company does not split its stock, and the value of the company increases, each share becomes very expensive in itself. Selling a share of $135,000 Berkshire A stock may be something that people think about harder than selling a share of smaller stocks. Particularly since the high price of each share may also remind people that management has done a good job in the past.

2. Costs of the Split Itself: There are legal and notification costs to doing the split, since a company must make the appropriate Board of Directors resolution and then notify shareholders, exchanges, regulators, etc. It seems strange to spend the company’s money on a stock split that has no real significant effect on improving the value of the company.

3. Listing Requirements: To be listed on a stock exchange stocks generally must maintain a certain minimum price per share. If a company splits its stock and then the value of the company itself falls, the shares may fall below this requirement and be delisted from the exchange. Some companies that fall into this situation execute a reverse stock split in order to stay exchange listed.