7.6 Stock Splits
Questions:
- What is a “Stock Split”?
- There are Stock Splits and “Stock Dividends.” What is the difference? We will discuss both.
Example of a Stock Split
We shall examine a stock split for each 100 shares of stock outstanding. Originally, we will say that the stock is worth $100 per share, and the company decides to “split” the shares on a two-for-one basis. For every share one owns, s/he will now have two shares at half the original value.
Originally: 100 s. @ $100/s.
After Split: 200 s. @ $50/s.
- Take note that, financially, a stock split, in the short-run, is a non-event, as the total share value has not changed. The value is still $10,000 – per 200 shares. The company’s total equity is unaffected. There is no change in capital structure. Debt Ratios are unaffected because there is no change in the dollar value of the firm’s total equity (nor of the debt).
- Since the shareholder now has twice as many shares as before, we might also describe this event as a 100% “stock dividend.” The investor has now received more shares than s/he had before.
- Companies will split shares if they feel the price is too high. A lower price could encourage more trading in the shares and thus more efficient price discovery.
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- At this writing (2022.04.12), Berkshire Hathaway “A” shares exceeded $523,803 per share. Warren Buffet discourages trading as his investment philosophy demands “buying and holding.” One needs a lot of money to purchase just one share. High share prices may indeed discourage trading, although this case is extreme.
Example of a Stock Dividend
Technically, there is no difference between a stock split and a stock dividend. They are mathematically the same. The difference is merely a matter of degree. Recall that in the case just above, we had a 100% stock dividend, but the market will refer to it as a “2/1 split.” A stock split that is equivalent to, or less than, 25% is considered a “stock dividend.”
Stock Dividend Example: 5/4 stock split = “25% stock dividend”
For every 100 original shares, the investor now has 125 shares. Again, the “rule” is that up to 25%, it is called a “stock dividend.” Greater than 25% is called a “stock split.”
Example of a Reverse Stock Split
This is the exact reverse of our original case above, and thus requires little explanation. Now, we will have a one-for-two reverse stock split. Again, total value will not be changed. For every share owned, the investor will now have one-half a share at twice the value.
Originally: 200 s. @ $50/s.
After Reverse Split: 100 s. @ $100/s.
- Low-priced shares, especially if in single digits, are often viewed, psychologically, as bad investments. Companies do reverse splits in order to raise share prices and thereby make the shares more credible to the public.
- Additionally, shares trading at under $1 may be de-listed from the New York Stock Exchange.
Bottom Line: Stock Splits and Stock Dividends have NO Capital Structure implications. However, this is not so for Cash Dividends and Stock Buybacks. Let’s see.