When a company announces a stock split, it is announcing a forward split. A forward stock split occurs when investors on record receive additional shares for every share they own. If the company does not have enough treasury stock to cover the additional shares it needs to complete the split, executives call for a vote from shareholders with voting rights to increase the number of authorized shares.
Authorized Shares and Treasury Stock
At its inception, the original founders or board of directors of a company decide how many shares of stock to authorize. Often the largest portion of authorized shares include the number of shares the company wants to sell to the investing public, issue as stock options and shares awarded to high-level executives as a part of their compensation package. The authorized shares the company does not sell, offer as options or offer as compensation are called treasury stock.
Treasury Stock and Splits
Before a stock split can move forward, voting shareholders must approve the split. When a company decides to split its stock, it can pull shares from its treasury stock account. If it does not have enough shares to cover the split, it must obtain permission from the board to increase the number of authorized shares to complete the split. Once the split is complete, the number of shares outstanding increases and the price per share decreases.
Effect on Shares Outstanding
One effect of a stock split is that it increases the number of shares outstanding because each shareholder receives an additional amount of shares for every one share they own prior to the split. For example, in a three-for-one split, shareholders receive two additional shares for every one share they currently own. So, if an investor owns one share before the split, he owns three shares after the split. Also, if the company had one million total shares outstanding before the split, it has three million total shares outstanding after the split.
Effect on Price
The price per share does not stay the same after a stock split. Meaning, the total market value of the stock does not increase. Since a stock split increases the number of shares outstanding, but does not increase the stock’s total market value, the price per share must decrease. For example, a company has 100 shares outstanding at $10 per share. The total market value of the shares prior to the split is 100 x $10 = $1,000. It announces a two-for-one split. This increases the number of shares outstanding to 200 (100 x 2 = 200) but decreases the price per share to five dollars. The total market value after the split is 200 x $5 = $1,000. This is the same as it was before the split.