Stock Split

In a stock split, a company will divide each share of its existing stock into multiple shares to
bring down the company's stock price.

Example:
Suppose Newco's stock reaches $60 per share. The company's management believes this
is too high and that some investors may not invest in the company as a result of the initial
price required to buy the stock. As such, the company decides to split the stock to make the
entry point of the shares more accessible.

For simplicity, suppose Newco initiates a 2-for-1 stock split. For each share they own, all
holders of Newco stock therefore receive two Newco shares priced at $30, and the
company's shares outstanding double. Keep in mind that the company's overall equity value
remains the same. Say there are 1 million shares outstanding and the company's initial
equity value is $60 million ($60 per share x 1 million shares outstanding). The equity value
after the split is still $60 million ($30 per share x 2 million shares outstanding).

What Is a Stock Split?

A stock split is a corporate action that increases the number of the corporation's outstanding
shares by dividing each share, which in turn diminishes its price. The stock's market
capitalization, however, remains the same, just like the value of the $100 bill does not
change if it is exchanged for two $50s. For example, with a 2-for-1 stock split, each
stockholder receives an additional share for each share held, but the value of each share is
reduced by half: two shares now equal the original value of one share before the split.

Let's say stock A is trading at $40 and has 10 million shares issued, which gives it a
market capitalization of $400 million ($40 x 10 million shares). The company then decides to
implement a 2-for-1 stock split. For each share shareholders currently own, they receive
one additional share, deposited directly into their brokerage account. They now have two
shares for each one previously held, but the price of the stock is cut by 50%, from $40 to
$20. Notice that the market capitalization stays the same - it has doubled the amount of
stocks outstanding to 20 million while simultaneously reducing the stock price by 50% to
$20 for a capitalization of $400 million. The true value of the company hasn't changed at all.

The most common stock splits are, 2-for-1, 3-for-2 and 3-for-1. An easy way to determine
the new stock price is to divide the previous stock price by the split ratio. In the case of our
example, divide $40 by 2 and we get the new trading price of $20. If a stock were to split 3-
for-2, we'd do the same thing: 40/(3/2) = 40/1.5 = $26.6.

It is also possible to have a reverse stock split: a 1-for-10 means that for every ten shares
you own, you get one share. Below we illustrate exactly what happens with the most
popular splits in regards to number of shares, share price and market cap of the company
splitting its shares.
What's the Point of a Stock Split?
There are several reasons companies consider carrying out a stock split.

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 is
unaffordable. Splitting the stock 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 prices rises, they have more
stock to trade.

Another reason, and arguably a more logical one, for splitting a stock is to increase a
stock's liquidity, which increases with the stock's number of outstanding shares. When
stocks get into the hundreds of dollars per share, very large bid/ask spreads can result. A
perfect example is Warren Buffett's Berkshire Hathaway (NYSE:BRK.A

Berkshire Hathaway Inc

BRK.A
245,220.00
-0.01%
), which has never had a stock split. Its bid/ask spread can often be over $100, and as of
November 2013, its class A shares were trading at just over $173,000 each.

None of these reasons or potential effects agree with financial theory, however. If you ask a
finance professor, he or she will likely tell you that splits are totally irrelevant - yet
companies still do it. Splits are a good demonstration of how the actions of companies and
the behaviors of investors do not always fall in line with financial theory. This very fact has
opened up a wide and relatively new area of financial study called behavioral finance.

Advantages for Investors

There are plenty of arguments over whether a stock split is an advantage or disadvantage
to investors. One side says a stock split is a good buying indicator, signaling the company's
share price is increasing and therefore doing very well. This may be true, but on the other
hand, a stock split simply has no effect on the fundamental value of the stock and therefore
poses no real advantage to investors. Despite this fact, investment newsletters have taken
note of the often positive sentiment surrounding a stock split. There are entire publications
devoted to tracking stocks that split and attempting to profit from the bullish nature of the
splits. Critics would say this strategy is by no means a time-tested one and is questionably
successful at best.

Factoring in Commissions
Historically, buying before the split was a good strategy due to commissions weighted by
the number of shares you bought. It was advantageous only because it saved you money
on commissions. This isn't such an advantage today as most brokers offer a flat fee for
commissions, charging the same amount for 10 shares or 1,000. Some online brokers have
a limit of 2,000 or 5,000 shares for a flat rate, however most investors don't buy that many
shares at once.

The Bottom Line

Remember that stock splits have no effect on the worth (as measured by market
capitalization) of the company. A stock split should not be the deciding factor that entices
you into buying a stock. While there are some psychological reasons why companies will
split their stock, it doesn't change any of the business fundamentals. In the end, whether
you have two $50 bills or one $100 bill, you have the same amount in the bank.

Stock Dividends
Stock dividends are similar to cash dividends; however, instead of cash, a company pays
out stock. As a result, a company's shares outstanding will increase, and the company's
stock price will decrease. For example, suppose Newco decides to issue a 10% stock
dividend. Each current stockholder will thus have 10% more shares after the dividend is
issued.

Stock Repurchase
A stock repurchase occurs when a company asks stockholders to tender their shares for
repurchase by the company. This is an alternate way for a company to increase value for
stockholders. First, a repurchase can be used to restructure the company's capital structure
without increasing the company's debt load. Additionally, rather than a company changing
its dividend policy, it can offer value to its stockholders through stock repurchases, keeping
in mind that capital gains taxes are lower than taxes on dividends.
Advantages of a Stock Repurchase

Many companies initiate a share repurchase at a price level that management

deems a good entry point. This point tends to be when the stock is estimated to be
undervalued. If a company knows its business and relative stock price well, would it
purchase its stock price at a high level? The answer is no, leading investors to
believe the management perceives its stock price to be at a low level.
Unlike a cash dividend, a stock repurchase gives the decision to the investor. A
stockholder can choose to tender his shares for repurchase, accept the payment and
pay the taxes. With a cash dividend, a stockholder has no choice but to accept the
dividend and pay the taxes.
At times, there may be a block of shares from one or more large shareholders that
could come into the market, but the timing may be unknown. This problem may
actually keep potential stockholders away since they may be worried about a flood of
shares coming onto the market and lessening the stock's value. A stock repurchase
can be quite useful in this situation.

Disadvantage of a Stock Repurchase

From the perspective of an investor, a cash dividend is dependable, usually

quarterly. A stock repurchase, however, is not. For some investors, the dependability
of the dividend may be more important. As such, investors may invest more heavily
in a stock with a dependable dividend than in a stock with less dependable
repurchases.
A company may be in a position where it ends up paying too much for the stock it
repurchases. For example, say a company repurchases its shares for $30 per share
on June 1. On June 10, a major hurricane damages the company's primary
operations. The company's stock therefore drops down to $20. Thus, the $10-per-
share difference is a lost opportunity to the company.
Overall, stockholders who offer their shares for repurchase may be at a
disadvantage if they are not fully aware of all the details. As such, an investor may
file a lawsuit with the company, which is seen as a risk.

Price Effect of a Stock Repurchase

A stock repurchase typically has the effect of increasing the price of a stock.

Example: Newco has 20,000 shares outstanding and a net income of $100,000. The current
stock price is $40. What effect does a 5% stock repurchase have on the price per share of
Newco's stock?

Answer: To keep it simple, price-per-earnings ratio (P/E) is the valuation metric used to
value Newco's price per share.

Newco's current EPS = $100,000/20,000 = $5 per share

P/E ratio = $40/$5 = 8x
With a 2% stock repurchase, the following occurs:
Newco's shares outstanding are reduced to 19,000 shares (20,000 x (1-.05))
Newco's EPS = $100,000/19,000 = $5.26

Given that Newco's shares trade on 8 times earnings, Newco's new share price would be
$42, an increase from the $40 per share before the repurchase.