Stock splits are a type of corporate "event" in which the company's board of directors agree to declare an increase -- or decrease -- in the number of shares outstanding in the public market (called the "float"). Splits have have no impact on the operation or profitability of a company. They are simply a change in float.
Understanding Market Cap
A company's market cap (or market capitalization) is the product of the total number of shares outstanding times the market price of the stock. For example, if company XYZ has 180 million shares in the public float and the share price is $40 per share, the market cap is $7.2 billion dollars. If share prices double and rise to $80, the market cap also doubles to 14.4 billion dollars.
Why Are Stock Splits Declared?
The primary reason a company's board of directors declare a stock split is to keep share prices at a price level that makes them more marketable to small investors. This also has the added benefit of increasing the total number of shares outstanding without issuing new shares. More shares in the float increases trading volume (liquidity) which is also attractive to large institutional investors such as mutual funds. Stocks with more attractive (lower) prices and a larger float can increase demand for the stock -- within reason -- depending on the performance of the company itself.
It's important to note, however, that some stocks do not split. Berkshire Hathaway, Warren Buffett's holding company, have never split since it became publicly traded in the late 1950s. (Share prices are well over $100,000 as of January 1, 2011.)
Examples of Splits
In addition to "when" or how often a stock might split, there is also the question of the form the split takes. First, company boards typically have no set time-frame for splits. Rather, they make these decisions based on general price levels, the prospects for the performance of the company itself and the overall condition of the stock market.
Stock splits can be effected in any number if ratios, but the most common are 2:1, 3:1, 3:2, 4:1, 5:1 and so on. In a 2:1 split, 100 pre-split shares held at $60 dollars each will become 200 at $30 each. A 3:1 split of 100 shares at $60 would become 300 shares at $20, post-split.
There is no set requirement, but mature, stalwart-type companies with larger market caps and slower growth perform smaller splits unless the stock price has had unexpectedly sharp advance. Younger, high-growth companies often experience rapid appreciation and will, on occasion, conduct larger splits.
If a company has fallen on hard times, they may perform a reverse split; American International Group (ticker: AIG) is an example of this. In the financial crisis of 2008 to 2009, AIG's shares declined to below $1 -- the NYSE minimum -- and were at risk of being de-listed. A 1:20 reverse split was conducted on July 1, 2009. 100 shares at $1 became 5 shares at $20. Usually, reverse splits are a sign of a very troubled company.
Stock Split Tendencies and Investor Enthusiasm
There is an old market adage that says, "stocks that hit $80 soon hit $120." In a bull market, this seems true since people will buy the shares in anticipation of a stock split being declared. In reality, the investor still has the same amount invested on the day of the split as the day before. But, any price changes in the short periods before or after are principally due to the psychology of the traders/investors, and are generally short-term in nature.
Moss Strohem has a background in business and finance, and an avid interest in youth sports, health, nutrition and physiology. He writes both technical information and market commentary as a private consultant and has researched and authored business plans.