stock split

A stock split is an operation in which the shareholder's capital is re-divided over a different number of shares. This is done to make trading easier, or to make a share "seem" cheaper or more valuable. To see why a company would do such a thing, we will consider two extreme cases.

First, consider a company of which the total value of the shares is $10 million dollars. Now, imagine this company were to split its capital in 10 shares of $1 million each. This means that you either spend a cool million bucks and become one of the lucky shareholders in the company, or you don't, and you own nothing. Trading becomes very difficult, as only people who can and want to buy a very large portion of the company can trade. In effect, it is technically possible to trade the shares, but it is practically impossible

Now, let's consider the other extreme: we are going to cut up the company into tiny bits, 100 million of them, each worth ten cents. This mean anyone can own just as much of the company as he or she wants, up to a 10 cent precision. You want to have exactly 5950,76 dollars of exposure? Just buy 59507 shares and put the 6 cents in a tip jar. Unfortunately, there is a problem. You see, on a stock exchange, there are always two prices: a bid price, at which we can sell, and an ask price, at which we can buy. These are typically separated by a minimum price differential, which we will assume to be 1 cent (exchanges are moving to smaller price differentials, but even for a 0.1 cent price differential, the argument remains valid). If I buy shares, I pay 11 cents, and if I sell shares, I only get 10. This means buying and selling shares will cost me around 10% of my capital, which is massive. Furthermore, we can now never know the value of the company with more than 10% precision-is the share price closer to 10 or 11 cents?

To avoid such problems, most companies strive to keep their stock price in a range between, say, 5 dollars or euros and 100 dollars or euros. This is small enough to allow even private investors to control exactly how much they want to invest, but large enough so the bid-ask spread doesn't become prohibitive.

So, how do companies manage to remain in this desirable share price range? Well, they do a stock split. Imagine the stock trades around $150, and has done for quite some time. This is a bit on the high side, so the company might decide to split the shares. They could split them in 2, giving each holder of a $ 150 share now two $75 shares. Or, they could just be drastic and split it 5 ways, giving each shareholder 5 $30 shares. Anything is possible, although as far as I know, a company needs permission from a majority of its shareholders to carry out a stock split

The opposite, a reverse split, is more rare. In this scenario, a number of old shares are converted to one new share. Imagine one share is worth $1.31, and the company decides to do a 10:1 split. For each 10 old shares, you get 1 new share, valued at $ 13.10.

Reverse splits tend to be a bit rare, as such low prices per share only tend to happen when a companies' shares have just been slaughtered. In such a case, an optically cheap share at $0.30 might be more desirable than a 100:1 reverse split. The new $30 shares would look more expensive, which would make the way down all that much easier. Pure psychology, of course, but stock splits in general are a game of smoke and mirrors. By the way, stock dividends are in fact nothing but a reverse stock split with a percentage of (dividend + ex-dividend share price)/(ex-dividend share price). The number of shares has grown, but the company hasn't, so to speak - more smoke and mirrors.

You might wonder what will happen with people owning derivatives, say options on the shares. Well, without going into details (visit the website of your local exchange), these people also receive a stock split over their options, so they get more options with a lower strike price, in such a way that the value stays constant.

In summary, a stock split is a redistribution of the companies' capital over a different number of shares. This is done to make the shares more easily tradable. Unless the share price is extremely high or low (think lower than a dollar or more than a thousand dollars), the effect is largely cosmetic.