Say you had a $100 bill and someone offered you two $50 bills for it. Would you take the offer? This might sound like a pointless question, but the action of a stock split puts you in a similar position. In this article we will explore what a stock split is, why it's done and what it means to the investor.  

What Is a Stock Split?
A stock split is a corporate action that increases the number of the corporation's outstanding shares by dividing each share, which in turn diminishes its price. The stock's market capitalization, however, remains the same, just like the value of the $100 bill does not change if it is exchanged for two $50s. For example, with a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share is reduced by half: two shares now equal the original value of one share before the split.

Let's say stock A is trading at $40 and has 10 million shares issued, which gives it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to implement a 2-for-1 stock split. For each share shareholders currently own, they receive one share, deposited directly into their brokerage account. They now have two shares for each one previously held, but the price of the stock is split by 50%, from $40 to $20. Notice that the market capitalization stays the same - it has doubled the amount of stocks outstanding to 20 million while simultaneously reducing the stock price by 50% to $20 for a capitalization of $400 million. The true value of the company hasn't changed one bit.

The most common stock splits are, 2-for-1, 3-for-2 and 3-for-1. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. In the case of our example, divide $40 by 2 and we get the new trading price of $20. If a stock were to split 3-for-2, we'd do the same thing: 40/(3/2) = 40/1.5 = $26.6.

It is also possible to have a reverse stock split: a 1-for-10 means that for every ten shares you own, you get one share. Below we illustrate exactly what happens with the most popular splits in regards to number of shares, share price and market cap of the company splitting its shares.


What's the Point of a Stock Split?
So, if the value of the stock doesn't change, what motivates a company to split its stock? Good question. There are several reasons companies consider carrying out this corporate action.

The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more "attractive" level. The effect here is purely psychological. The actual value of the stock doesn't change one bit, but the lower stock price may affect the way the stock is perceived and therefore entice new investors. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before, and of course, if the prices rises, they have more stock to trade.