FinancialManagementPro.com

Stock Splits

By Yuriy Smirnov Ph.D.

Definition

Stock split is a corporate action usually taken when the management of a company believes that the stock price is too high for investors. There are several reasons why a split is made.

  1. To improve liquidity in the stock market. The bigger the number of shares in free float, the higher their liquidity.
  2. To make shares more affordable for investors. Since shares are traded in standardized lots of 100 units, a stock split makes them cheaper. Let’s assume that the stock price is $120 and management announces a 3-for-1 stock split. The stock price will drop by 3 times to $40. Before the split, an investor needs $12,000 (100 × $120) to buy 1 lot. After the split, this amount reduces to $4,000 (100 × $40).

Thus, the stock split allows the stock price to be maintained within an optimal range.

Effect on stock price

The stock split increases the number of shares outstanding and decreases the par value and stock price. For example, a 2-for-1 split will double the number of shares outstanding, and the stock price and par value will decrease by half. The number of shares of each shareholder will remain unchanged, however, as will the total value of the stock.

Theoretically, the stock split should not lead to either an increase or a decrease in the market value of the company, but a number of empirical studies have shown this is not always the case.

Investors consider the announcement of a split as a signal that management expects a further increase in the stock price and tries to hold it within an optimal range. Therefore, the stock price will usually increase some time after the announcement. If, however, after some time a company does not demonstrate a substantial increase in earnings, its stock price will usually decline.

Effect on options

The effect of a stock split on options depends on whether or not it is an integral number (e.g., 4-for-1 or 3-for-1), not (e.g., 3-for-2).

An investor has one July call option contract with a strike price of $150. The underlying asset is 100 shares of stock of Total SE Inc. Let’s suppose that Total SE Inc. announces a 3-for-1 split to be made on 06/15/20X9. That means that its stock will be traded on a split basis starting 06/16/20X9. From this date, the investor will own 3 July call option contracts of 100 shares each with a strike of $50 ($150 ÷ 3).

Let’s assume that Total SE Inc. declared a 3-for-2 split instead of 3-for-1. That means the number of shares outstanding will increase by half, and the stock price will decrease by one-third. In such a case, the existing July call option contract should be adjusted as follows:

New number of shares = 100 ÷ 2 × 3 = 150

New strike price = $150 ÷ 3 × 2 = $100

Journal entry

When a stock split is made, the only journal entry required to be made is a memorandum entry. It is necessary to note the new number of shares outstanding and the new par value.

Please note that it does not affect any account and therefore has no effect on the balance sheet or equity!

Advantages and disadvantages

The key advantage of a stock split is an increase in the number of shares outstanding and therefore an increase in free float. Along with the fact that the stock price is decreasing in proportion to the split ratio, this makes them more affordable to investors and increases their liquidity.

The disadvantage of a stock split for investors is a greater stock trade fee because brokers often set up a flat fee per round lot (100 shares). That means an investor will pay a lower fee when buying “expensive” shares than “cheap” ones.

Assume that the brokerage fee is $10 per 1 round lot and the investor is going to invest $ 15,000. There are two investment alternatives: stock of Company A at $150 per share and stock of Company B at $5 per share. Therefore, the investor may buy 1 round lot of stock of Company A (100 × $150 = $15,000) or 30 round lots of stock of Company B (100 × $5 × 30 = $15,000). However, the brokerage fee will be $10 when buying stock of Company A and $300 (30 × $10) when buying stock of Company B.

Please note that many brokers have a flat fee per trade, so it does not matter how many round lots are bought at once.

Example

The stock price of Total SE Inc. has reached $80. A company’s management believes that the price is too high for investors and decides to declare a 4-for-1 stock split.

That means each stockholder will get 4 shares instead of 1 he or she owned. At the same time, the stock price drops to $20, and the number of shares outstanding will increase by 4 times.

Let’s assume that the number of shares outstanding before the split announcement was 200,000. Therefore, the value of the company is $16,000,000 ($80 × 200,000). After the split date, the number will increase by 4 times to 800,000. The value of the company, however, remains the same at $16,000,000 ($20 × 800,000).