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Friday, 30 April 2004
"A reader writes" What does a stock split mean?


Hello Friends! Thanks again for stopping by. I got another email from Jason M. who writes:

Hey Bob,

As the one person in the world of advice that doesn't
make me feel bad for asking dumb questions, I would
like to throw yet another one your way.

What does a stock split mean and how does it effect a
stock?

Thnx again for everything.
J.


Well Jason, I was always told there are NO dumb questions, and I believe that is the case. Many of us have assumptions about our understanding of things that may be totally off base, so if you are not sure about something, never hesitate to ask! And you KNOW I like to get emails!

Basically, a stock split comes in the form of a "dividend." That is, a distribution to current stock holders of additional shares of stock. Sometimes, and I will comment on this in a second, the split is what is called a "reverse split" where actually shares are "redeemed" from shareholders so there are actually LESS stocks outstanding. But the stock distribution, or additional shares, is the usual route.

Let me try to explain this with a simplified example. Let's assume we have a company that makes widgets and has ten shares outstanding. In other words, anyone who has one of the shares owns 10% of the company. For argument's sake, let's say that the world figures this company is worth $100. That is, if you could buy all of the ten shares, it would cost you $100. Thus, each of the ten shares would be worth $10. The total value of the shares, calculated by multiplying the price/share by the # of shares would be $100 or as we like to refer to it, the "Market Capitalization" of this widget company is $100. I hope you are following me!

Next, let's say that the CEO of the company and the shareholders decide that they wold like to have more people have shares of stock....and that they would like the stock pricer to be cheaper so more people could own shares. What they decide to do is to distribute an additional 10 shares to existing shareholders. This doesn't actually make the company worth any more! They are just sending out pieces of paper, stock shares, to each shareholder. In fact, each shareholder would be entitled to one additional share of stock. Thus, there would be a total of twenty shares in our example, and since the company presumably is not worth any more, the value of the company would be $100/20 or $5/share.

This is what happens in real life. With a 2:1 stock split, this means that for each share you had previously, you will now have two shares. This is also called a 100% stock dividend. Other types of split are also possible. For instance, a 50% stock dividend means that for every TWO shares you have, you will now have THREE or, it may also be referred to as a 3:2 split.

Sometimes when stock prices get incredibly cheap, into the pennies sometimes, the company may choose to do a REVERSE stock split to increase the price of the stock. How does that work? For instance if you have a 1:5 split, a reverse split, you would be issued a new share and five old shares would become worthless. The price of the stock would presumably also increase five-fold not because the company was WORTH any more, but just because the SAME value of the company was now divided among FEWER shares.

PHEW....I didn't mean to go on so long. I hope you followed my discussion. I know you had another question, and I will get to that shortly!

Thanks so much again for inquiring and I hope that my answer was helpful to you! If you or anyone else has any other questions, I would be happy to try to give you an explanation (as long as I understand the answer!)...just email me at bobsadviceforstocks@lycos.com

Bob


Posted by bobsadviceforstocks at 12:52 PM CDT | Post Comment | Permalink

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