The Primary Purpose of a Stock Split

by Tim Plaehn

A publicly traded company uses a stock split to make its shares more appealing to a wider number of investors. For a company with a long-term history of growth, the share price could climb to a very high, unattractive price if the occasional stock split was not used to adjust the share value. A split also does not affect the investment value of existing shareholders.

Stock Split Mechanics

A company declares a stock split that includes a ratio of new shares for existing shares. Typical split ratios include 2 for 1, 3 for 1, 3 for 2 and 5 for 2. On the effective date of the split investors holding shares in electronic form in their brokerage accounts will see a new number of shares based on the ratio. Investors with share certificates will receive more certificates. For example, an investor with 100 shares of a stock declaring a 5 for 2 split will have 250 shares on the day the split is effective.

Share Price Effects

Unfortunately for investors, getting a bunch of new shares from a stock split does not come with a big investment gain. At the same time the split results in more outstanding shares, the share price adjusts by the reverse of split ratio. So if the stock price was $100 before the 5 for 2 split, after the split the stock will trade at $40. So the investor with 100 shares pre-split has an investment worth 100 times $100 or $10,000 and 250 times $40 or $10,000 after the stock split.

Adjusting Share Value

Although a stock split wording changes the number of shares held by investors, the goal is to adjust the share price. Many companies believe their shares will be more attractive to new investors if the share value is at a lower level. In the example 5 for 2 stock split, the company may believe that a $100 share price is too rich for many investors and a $40 share price will result in a wider interest in the stock. The actual investment value for shareholders has not changed, only the perceived value.

Historical Examples

The effects of a corporate policy of stock splits when the share price reaches a certain level can be graphically illustrated by looking at the split histories of companies that have a long history of successful growth. Since going public in 1969 Walmart has declared 11 stock splits. As a result, an investor who bought 100 shares in 1969 and not sold any shares would own 204,800 shares in early 2013. Coca Cola has declared 11 splits in its 90-year history and an investor who bought 100 shares way back in 1919 would own 921,600 shares today.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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