What is a Stock Split?

what-is-a-stock-split

As the name suggests, with a share split the firm can reduce the share price by increasing the number of shares outstanding. For example, a 3 for 2 share split means that for every 2 shares an investor owns, a third share is issued for free. With a share split, the firm aims to keep the stock price within a trading range that provides the most liquidity.

No journal entry is needed, as the number of shares increases by some factor, all per-share based figures decrease proportionally.


Stock Split Example

Not all firms split their shares. At the time of this writing (January, 2010), Google’s share price was $620 per share. Even though most investors are able to pay a single share, it will prevent (some) shareholders to buy Google shares if (for example) they want to buy a put option to limit their risk. One option contract relates to 100 underlying shares.

The ask-price of a January 2012 put option with a strike of $620 was $90,70 (giving the option holder the right (and not the obligation) to sell 100 shares for $620 until January 2012). As 1 put option relates to 100 underlying shares, the ask price for one contract is $9070. Thus, an investor who wants to reduce downside risk will needs to own 100 shares worth $62,000 such that the option contract matches the number of shares. In this case, for example a 10-1 share split would reduce the required sum by a factor 10.

A reverse split can be used in the situation where a share is trading at a (very) low price range (for example a penny stock).


Stock Splits Explained

Key points:

– with a share split, the number of shares increase by some factor, while at the same time the par value per share decreases by the same factor, leaving the value of common shares unchanged (no journal entry is necessary)

– share splits are performed so that the share price is in a ‘normal’ trading range

– a reverse split is used when the share price is very low

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