Stock Split - Wanderer Financial - Stock Trading Newsletter for the Wandering Soul

Stock Split

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To test a child's knowledge of money and math (and as an easy way to make a buck) I will sometimes offer my niece or nephew two nickels in exchange for just one quarter. Sometimes I'll even sweeten the pot and offer 5 pennies for just one quarter. Depending on the age of the child, getting two or more coins in exchange for just one seems like a great deal. Once they can do the math though, I end up looking for a different way to make some money.

I bring this up because APPL just announced it is splitting its stock 4:1. That means that, once the split takes place, each stockholder will be four times richer than they were before because they will have four times as many shares as they had pre-split. Right? Well, no. If only it worked that way! The reality is much more boring. A stock split is more akin to getting four quarters in exchange for one dollar bill.

When a corporation goes public, they issue a set amount of shares. Over time, those shares become more valuable. Since most brokers will sell a minimum of one share, it can get to the point where even a single share is too rich for some small investors. For example, if you have a $500 portfolio, then a stock that costs $1500 per share is going to be unobtainable. To resolve this problem, corporations will often do a stock split. The stock split may be a two for one, three for one, or any other combination. The important thing to understand is that when a stock splits, the total value of what you have hasn't changed.

Think in terms of money. If you owned one dollar, and one dollar was equal to one share, then you own one share worth one dollar. Now if we assume the company decides to do a 4-for-1 stock split, like Apple currently is, you'll have four shares instead of just one, but the combined value of them is still only one dollar. In other words, you exchanged your dollar bill for four quarters.

Sometimes, stocks will do a reverse stock split. This is especially common with leveraged ETF's. Over time the ETF can drop so low in price, that a single share becomes too cheap to qualify for certain indexes. To remedy the situation, the corporation may do a stock split in reverse. In this case, assume you had four quarters worth one dollar. A four for one reverse stock split simply exchanges four quarters for one dollar bill. Again, the total value remains unchanged. Only the price of the share, and the quantity of shares changes, but your holding remains the same.

It is often assumed that a stock split will be accompanied by a jump in the stock price. The reasoning for this is that the stock is now more affordable for small investors. Studies haven't really bore that out, though. The fact is, stocks are much more influenced by the heavy hitters in the market than they are by the retail traders who can't afford to buy a $1,000 stock. It would take a lot of those little traders to influence a stock's price in any meaningful way.

So, overall, there isn't much to a stock split. The market cap of the company is not influenced, only the number of shares outstanding is. If you own 1 share worth $100 or 4 shares worth $25, you still own $100 worth of stock.