What Is a Stock Split?

by James Brumley | April 24, 2014 8:51 am

The term “stock split” is about to be bandied about ad nauseam thanks to Apple (AAPL[1]) announcing a 7-for-1 stock split alongside its Wednesday evening earnings report.

Source: Flickr[2]

But while the term might sound unfamiliar or even intimidating to new investors, they’re certainly nothing to fear.

A stock split is just a relatively routine maneuver made by corporations in an effort to keep the price of their stock low, so would-be investors don’t feel like they’re paying a fortune just to own a stake in a particular company.

Thing is, though, when all is said and done, a stock split is essentially the equivalent to turning a dollar bill into an equivalent amount of coins.

How Prices Work in a Stock Split

An example may best illustrate the idea of a stock split:

Suppose normal sales and earnings growth for a company over a period of years has caused the price of a particular stock to move from $10 per share to $200 per share. While this kind of capital appreciation is the goal of growth investing, that higher per-share price might cause investors to view (and value) that particular stock differently than they might a much lower-priced stock.

More specifically, it’s likely that a small-time investor would balk at paying $200 per share of any company, whereas a price of $10 per share simply feels more palatable.

A company can alleviate that potential psychological hurdle by converting one expensive share of stock into several less expensive shares of the same stock.

Sticking with the above example, a corporation could push the price of that $200 stock down to $10 per share by giving shareholders 20 shares of the lower-priced stock for every one share of the higher-priced stock they own. In this case, it would be a 20-for-1 split. (Although it should be noted that stock splits can and do come in all shapes and sizes … 2-for-1, 3-for-2. And of course, in the case of AAPL, 7-for-1.)

Though less common than stock splits, a company can effect a reverse stock split as well. This is generally done when the price of a particular stock has fallen to such low levels that it’s being seen as too low to be taken seriously. Any stock priced below $5 per share is off limits to some institutional investors, and any stock priced below $2 per share is (weirdly enough) considered to be a penny stock — and is also off limits — by most large investment firms. Reverse splits can pump up the value of a low-priced stock by reducing the number of shares investors own.

For the average investor, though, reverse stock splits are rarely experienced. Most stock split activity will be of the conventional “more shares at a lower price per share” ilk.

Truth be told, though, the price level of any stock shouldn’t — and usually doesn’t — matter.

In the same sense that four quarters are equal to one $1 bill, 20 shares of a $10 stock is worth no less or no more to an investor than one share of a $200 stock. But, investors being human — with quirky biases — may simply find it mentally easier to invest in more shares of a lower-priced stock than they would one share of a stock with a higher per-share price tag.

What to Do If Your Stock Splits

As for the mechanics of a stock split, here’s the great news: Investors rarely have to do anything when splits occur.

Shares that are held at any reputable brokerage firm usually undergo the split process automatically; shareholders literally wake up one morning and find the number of shares of a company they owned has changed, as has the price per share.

Just remember: That particular investment as a whole, however, neither gains nor loses value due to the split. You have the same dollar amount worth of stock.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

  1. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  2. Flickr: http://www.flickr.com/photos/vjosullivan/

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