Concept of Stock Splits and its Value

The concept of Stock Splits and its Value to Shareholders

A stock split is similar to a stock dividend in an economic sense. It is a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares. When a company announces stock splits, it results into an increase in a number of outstanding shares with a proportionate decrease in par value and market price of the stocks. When a company declares a stock split, the number of shares of that company increases, but the market cap remains the same.

When a stock splits, it can also result in a share price increase following a decrease immediately after the split. Therefore, firms with exceptionally high market prices split their stocks in order to bring the market price within reasonable limits. As a result, small investors can purchase the company’s share. With a stock split, the total value of the shares of common stock outstanding remains unchanged along with no change in paid-in capital and retained earnings. Typically, a firm’s board of directors decides to split its stock in an effort to reduce its share price.

Example,

Suppose, a firm has the following total shareholder’s equity account before the stock split:

A. Common stock ( 4000 shares @ $10)……………….=$ 40,000

B. Additional paid-in capital………………………………….= $ 20,000

C. Retained earnings …………………………………………….= $ 90,000

Total shareholder’s equity (A+B+C)………………………= $ 150,000

The most common split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or three shares, respectively, for every share held earlier. If the firm announces 2-for-1 stock splits, it results into an increase in outstanding shares from 4,000 shares to 8,000 shares (i.e 4,000 shares x2) and reduction in the par value from $ 10 per share to $ 5 per share (i.e. $10 x 1/2). This keeps the value of common stock constant at $ 40,000 (i.e 8,000 shares x $ 5). Total shareholder’s equity accounts of the firm after 2-for-1 stock splits announcement appears as:

A. Common stocks ( 8,000 shares @ $ 5 each)………………..= $ 40,000

B. Additional paid-in capital……………………………………………..= $ 20,000

C. Retained earnings……………………………………………………….= $ 90,000

Total shareholder’s equity (A+B+C)………………………………..= $ 150.000

Unlike in stock dividend, a stock split does not involve a transfer of funds from retained earnings to paid-in capital and common stock accounts. There are two types of Splits: Forward Stock Splits and Reverse Stock Splits.

Stock splits do not change the proportionate ownership of the company.  In other words, the corporation takes the outstanding shares the shareholders owned and splits them into a larger number of shares still maintaining the same total value. Therefore, stock splits have no economic value to the investors or shareholders.

 

Information Source: