A:

The answer can be found in stock splits - or rather, a lack thereof. The vast majority of public companies opt to use stock splits, increasing the number of shares outstanding by a certain factor (e.g. by a factor of two in a 2-1 split) and decreasing their share price by the same factor.

By doing so, a company can keep the trading price of its shares in a reasonable price range. Most publicly-traded companies keep their share prices below $100 largely to maintain a reasonable share price range which ensures the liquidity of the stock is not eroded as the company increases in value. In simple terms, this means that if a company splits its shares every time it breaches the $100 mark, investors will be able to invest in the company in relatively small chunks, which can be advantageous when it comes to building a balanced equity portfolio.

A tenacious growth stock since its inception, Microsoft (MSFT) provides a good example of stock splitting used to maintain a reasonable trading range. Since 1987, MSFT has split nine times. In 1986, it was trading at about $30 a share - about the same price at which it traded in 2005. However, every time the stock split, its price was lowered and its number of shares doubled. Thus, to compare the actual price of 2005 to 1987, we need to use a split-adjusted price which removes the effects of the nine splits. When we do this, we find Microsoft's 1987 split-adjusted price is only about $0.08 per share, while the 2005 range is of course about $30. This means that Microsoft shares today are worth about 375 times what they were worth in 1987. If they had never split, Microsoft's shares would be trading in a range of over $10,000 per share!

Of course, since Microsoft has split so many times, this is not the case. But there are a few companies that, for one reason or another, choose not to use stock splits. Warren Buffett's holding company, Berkshire Hathaway, is the most prominent example. Since Buffett came to control the firm, its stock has never split, even while the share values grew substantially in each decade since the 1960s. Unlike Microsoft, Berkshire Hathaway's stock was already trading at more than $8,000 a share by the late '80s. In 2005, after roughly 40 years of split-free growth, Berkshire Hathaway Class A (BRK.A) shares trade for more than $80,000.

Whether a company is trading at $80,000 or $8, we can get a sense of its expensiveness by comparing its price to its earning potential. At the time of writing (Aug 2005), BRK.A has a 12-month trailing P/E ratio of a little under 20, while MSFT has a trailing P/E of roughly 24. By this measure, BRK.A shares are actually slightly less expensive than MSFT shares, even though they trade in much larger denominations.

(To learn more about equity valuations, read our Ratio Analysis Tutorial. To learn more about stock splits, see Understanding Stock Splits.)

RELATED FAQS
  1. How and why does a stock split?

    Learn why stock splits do not occur very often for individual stocks, and understand the impact of reverse stock splits on ... Read Answer >>
  2. What is a stock split? Why do stocks split?

    All publicly-traded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision ... Read Answer >>
  3. Can a mutual fund's shares split?

    Learn about mutual fund share splits and why they occur, including how splits and reverse splits affect share price and total ... Read Answer >>
  4. Does a stock split lead to the gapping up/down of the stock?

    If a company splits its stock, there will be no gapping of the stock due to the split itself. A stock split does not materially ... Read Answer >>
  5. What are reverse stock splits?

    A reverse stock split is a corporate action in which a company reduces the number of shares it has outstanding by a set multiple. ... Read Answer >>
  6. What happens to the value of a mutual fund when a stock splits?

    Find out what happens to the value of a mutual fund when a stock in its portfolio splits, including how stock splits work ... Read Answer >>
Related Articles
  1. Investing Basics

    If You Had Invested Right After Amazon's IPO

    Find out how much you would have made if you had invested $1,000 during Amazon's IPO, including how the power of the stock split affects investment growth.
  2. Investing Basics

    Stock Splits: A Closer Look At Its Effects

    Most trades, including short sales and options, aren't materially affected by a stock split. Still, it's important for shareholders to understand how these events impact various aspects of investing. ...
  3. Bonds & Fixed Income

    What Are Corporate Actions?

    Be a savvy investor - learn how corporate actions affect you as a shareholder.
  4. Fundamental Analysis

    Do Stock Splits Cause Volatility?

    Since stock splits decrease the stock price, do they also increase volatility because shares are traded in smaller increments? Investopedia examines assumptions about this increasingly common ...
  5. Investing

    Understanding Stock Splits

    Find out how stock splits work and how they affect investors.
  6. Investing Basics

    What Are Corporate Actions?

    Corporate actions are processes that change a company’s stock. Here are a few examples.
  7. Trading Strategies

    If You Had Invested Right After Apple's IPO

    Learn about how much a $1,000 investment in shares of Apple Incorporated would be worth if you invested at its initial public offering price.
  8. Stock Analysis

    If You Had Invested Right After Berkshire Hathaway's IPO (BRK.A)

    Learn how much you would now have if you had invested right after Berkshire Hathaway's IPO, and find out the classes of shares that you could invest in.
  9. Stock Analysis

    If You Had Invested Right After JPMorgan's IPO (JPM)

    Find out how much your investment would be worth in 2016 if you had purchased 100 shares during JPMorgan's IPO, including the impact of dividends and splits.
  10. Retirement

    Is Berkshire Hathaway Stock Suitable for Your IRA or Roth IRA? (BRK.B, BRK.A)

    Discover how Warren Buffett's Berkshire Hathaway is structured and if the company is appropriate for individual retirement accounts.
RELATED TERMS
  1. Stock Split

    A corporate action in which a company divides its existing shares ...
  2. Reverse/Forward Stock Split

    A stock split strategy that includes the use of a reverse stock ...
  3. Baby Berkshire

    Baby Berkshire refers to the 50:1 stock split after the market ...
  4. Split-Up

    A corporate action in which a single company splits into two ...
  5. Push Out

    One of two ways to effect a stock split. In a push out, new share ...
  6. Outstanding Shares

    A company's stock currently held by all its shareholders, including ...
Hot Definitions
  1. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  2. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  3. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  4. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  5. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  6. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
Trading Center