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Understanding Stock Splits

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1What Is A Stock Split?

How do stock splits work? Do I end up making more money from them? And should I buy companies that split their stock often? First, let’s look at why a stock splits and what happens. Stocks split because they reach a higher than desirable price. People just don’t want to pay 650 bucks a share for Google, ok. So company management feels people would rather pay 30 or 50 dollars a share, but not 650. So it’s a decision made solely by the board of directors for the company.

2How It Splits

Have you ever wondered what happens when a stock splits? Is it a good thing for the owners of the stock or a bad thing? What should you expect if the stock you own splits? When a stock splits 2 for 1, for example, the price gets cut in half and the owners of the stock double their shares. This means that if you own ABC stock and it is at the price of $50 and you own 100 shares, that’s $5,000, right? Then, when the stock splits, two-for-one, you would own 200 shares worth $25 each for a total value of $5,000. You follow? None of that is even a reason to buy a stock. You buy a stock because you want to invest in a company, and you believe in that company.

3A Real Life Example

A stock that has split 5 times since 1992 until 2006 and climbed up to new highs during that time is Lowe’s Home Improvement Stores. 5 splits is a lot of splits. When the stock split, owners got more shares but the stock adjusted down to offset it. Some would have said the owners of this stock had benefited because of the splits but that’s not the case. The stock rose because of the growth in Lowe’s earnings. The proof is that after the last split in 2006, when earnings turned down, the stock has lost money. Proof that the growth was not caused by the splits. So, remember, splits do not drive the stock price in the long run.

4Reverse Stock Split

Ever heard of one of those?  It often happens with lower priced stocks. In most cases Nasdaq stocks or stocks that trade on the Nasdaq Bulletin Board. A reverse stock split usually occurs with a low priced stock. Say a stock worth a dollar. If you owned 10,000 shares of a company, worth one dollar, then you have a $10,000 dollar investment. But company management could declare a reverse stock split. Let’s say they declare a 10 for 1 reverse split. The price of that dollar stock, would climb to 10 dollars; but your amount of shares would drop to 1000 shares. So you see, it’s the same $10,000 dollars. But in investor’s eyes, the price of a stock at 10 dollars is more attractive then at 1 dollar. And that’s how a reverse stock split works. For a real example, check out the price of Citigroup in 2011.

5What’s The Point Of A Stock Split?

After all, if the value of the stock doesn’t change, what motivates a company to split its stock? Good question. 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’s unaffordable. Splitting 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 stock price rises, they have more stock to trade. Psychological again.

I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.