Suppose a Mother has a twenty dollar bill and she wants to give $10 to each of her two children, who are going to different movie theaters the next day. So, while she is at the Bank, depositing some checks, she has the Teller exchange the one Twenty Dollar Bill for two Ten Dollar Bills. Either way, she still has only $20. That basically is what a Stock Split is–exchanging shares for multiples of those owned, and the value of each share is now reduced by that multiple. In the case of the Mother, one twenty dollar share is replaced by two ten dollar certificates. Much ado about nothing.
In actuality, if you own one hundred shares the day the stock splits, the transfer agent would merely credit your account (in a two-for-one split) with another 100 shares. Likewise, in a three-for-one split, your account would be credited for two more shares for each one that you own. This same approach would also be followed for any number of shares that you own–and for whatever the conversion factor.
Traditionally, investors who buy Individual Stocks have preferred to do so in 100 share increments, commonly referred to as a “Round Lot”. In days before Mutual Funds became popular, especially for the small investor, people bought stock of perhaps eight to ten different corporations–generally spread among various Industrials Sectors (i.e. Energy, Health Care, Technology, etc.)–in order to provide some diversification to their portfolio. They liked to trade in round share amounts, such as: 100; 150; 225; etc.
Recently, Google announced that was going to have a two-for-one stock split. So, if Google was trading at, let’s say, $605 per share, an investor would need $60,500 just to buy a round lot. And, that is for just the stock of one corporation. To diversify roughly evenly, among just eight–to-ten corporations, they would easily need somewhere around $500,000 to do so. Not everyone can afford to invest that much. Therefore, reducing the price per share enables more investors, who prefer to own Individual Stocks, to buy shares of that company.
Actively managed Mutual Funds solve part of the problem in that with one, or perhaps three or four, fund investments, diversification can be achieved. Basically, the investor just invests the amounts that they wish in the various securities. With mutual funds, however, you are deferring to the Investment Manager as to which securities to invest in, but some people prefer leaving it to the professionals anyway.
Conversely, companies sometimes declare “Reverse (Stock) Splits”. For instance, in March of 2011, Citigroup announced a one–for–ten Reverse Split, which actually took place in May of last year. In that case, the shares in your account would be reduced accordingly. If you owned 1000 shares, at let’s say $5 per share, after the reverse split, you would own 100 shares at $50 per share, assuming the market didn’t change. Either way, you would still have $5,000 invested in Citigroup. So, both Splits and Reverse Splits are basically a wash, with regard to actual Market Value.
But, why did “Citi” do this? Generally, when shares of a stock are quite low, especially falling into “Penny Stock” range (trading below $5.00 per share), there is a considerable reduction in marketability, and thus impairing the liquidity, as well. In fact, certain types of investors are not permitted, by law, to own penny stocks, or they just prefer to avoid them. So, a Reverse Split raises the price per share and eliminates a percentage of the outstanding shares–in this case, 90%.
In the scenario of the Mother paying for movie tickets, the children have just decided that they will both go to the same movie tomorrow. Accordingly, she can just give the $20 to the oldest child. Changing the twenty wasn’t necessary after all.