A stock split is a device that publicly held companies use to manage the share price of their common stock. Stock splits alter the number of outstanding shares issued by the company by a specific ratio, such as 3-for-2. The first number represents the number of new shares to be issued and the second number represents how many old shares are surrendered to get the specified number of new shares.
Calculating New Shares
When a stock that you own does a 3-for-2 split, the company issues three new shares for every two old shares you had at the time of the split. You calculate the number of new shares that you have after the split by multiplying the ratio of the stock split. With a 3-for-2 split, multiply your old share total by 3/2, or 1.5. For example, if you had 100 shares before the 3-for-2 split, multiply 100 by 1.5 to find you now have 150 new shares.
Purposes of Stock Splits
Companies often declare stock splits to keep share prices affordable, so as not to discourage smaller investors. For example, a smaller investor may feel that a company with a $2,000 share price is simply too much while a $40 share price is much more attractive. In addition, keeping the price lower increases the liquidity of the stock because the difference between the bid price and ask price is smaller. The bid price is the amount buyers are offering to pay while the ask price is the price at which a seller is offering the stock. For example, if a stock trades at around $1,000 per share, the difference between the bid and ask prices are likely to be farther apart than if the stock trades at $50 per share.
A stock split, whether 3-for-2 or any other ratio, does not change the theoretical value of the company. When a company performs a stock split, it does not change the overall capitalization of the company. For example, if a company has $5 million in assets and 10,000 shares issued, each share is backed by $500 of assets. If the company performs a 3-for-2 split, the company now has 15,000 shares outstanding, but only $333.33 in assets for each share. Therefore, each investors' shares are still backed by the same amount of assets.
Variations on Stock Splits
Companies may use a variety of ratios when performing stock splits. In addition to 3-for-2 splits, 2-for-1 and 3-for-1 splits are common. Sometimes, companies declare reverse stock splits. These occur when the companies consolidates shares. For example, a 1-for-2 stock split would leave the shareholder with just one share for every two shares he previously owned, or 50 percent. When a company performs a reverse split, the price of each share increases because there are fewer shares outstanding.
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