Understanding Stock Splits

By: Financial Shopper Network

    You just got your brokerage statement, and  notice 100 shares of XYZ stock instead of the 50 shares you purchased. The stock company sent you a proxy in the past, but maybe you were unaware, when the stock split was approved. Stock splits happen for a variety of reason but most companies follow the same pattern.

    When the price of a share of stock reaches say $130, it is not uncommon to see a forward stock split. Therefore the 50 shares, which have a value of  $6500,  will become 100 shares at $65 a share, when you have a 2:1 split. Notice the amount of the equity position, you have in the security did not change and would not as a result of a stock split.

    Companies mainly do stock splits for psychological reasons. They want their stock to be traded, otherwise their stock options and company stock may become stagnant. You are more inclined to pay $65 a share than $130. Even though people are going to make a purchase amount whether they purchase 50 or 100 shares, they feel at ease with the lower price. A famous exception to rule of stock splits is Warren Buffet's Berkshire Hathaway, he does not do forward stock splits to get more investors or to look more favorable.

    The reverse stock split is just the opposite. The company gives you less shares at a higher price. For example, you  have100 shares of ABC at $10 a share, but after a 2:1 reverse split, you have 50 shares at $20 a share. Again there is no change in your equity amount. Reverse stock splits are usually due to a decline in your stock price. Your stock is currently valued at $5 a share, maybe people will start thinking your business if failing. Therefore a quick way to increase the stock price would be to decrease the number of shares outstanding, thus increasing its price.

    The stock split is mainly used for psychological motives for a publicly traded company. When the stock gets too low, a reverse split may be in order to increase the price of a share. When the price is too high, the security may experience a forward split.