One of the fascinating myths that surrounds the stock market is the prospect that a certain stock may split, giving stock holders twice as many shares as before. What is badly understood by the outsider, although, is that even though the investor has more stock after a sock split, the value of each share is reduced. For an instance, if a corporation decides to split its stock 2-for-1, it issues one new share for each outstanding one. As well as at the same time, the value of each share is cut in half. As a result the stockholders now hold twice as many shares although the total value is the same as before the split. A stock split is like receiving 2 five-dollar bills for a single ten-dollar bill.
The company has a lot of it, to do with investor psychology. The price-per-share of a stock may be so elevated that the average investor feels it is out of his reach. A stock split reduces the price so that it may be more reasonably priced to smaller investors. In truth, the small investor could have purchased a smaller number of pre-split shares for the same price, but the appeal of buying a $20 stock as opposed to a $60 may be strong for some investors.
Stocks can be split by a number of ratios although the most common are 2-for-1, 3-for-2, and 3-for-1. Stocks can also be reverse-split, that is the company decreases the number of outstanding shares so that each stock holder has smaller amount of shares than before. Reverse stock splits are less common, although can be used for several reasons: the first one is the price per share may be so low that it appears as a poor investment; the second one is the company may be attempting to stave off possible delistment on the stock exchange; last but one is to push out minority stockholders; lastly as a way to go private.
Lower prices per share can outcome in greater liquidity, stocks are easier to trade at lower prices and there is less of a bid/ask spread. This is particularly true for stocks that are priced in the hundreds of dollars, small investors outlook them as out of their budget and the high bid/ask spreads (the difference between buying and selling prices) can put off bigger investors.
Other benefits of stock splits have to do with investor psychology. A split is usually seen as a bullish indicator, stock prices are rising and the company is doing well financially. There is generally a short-term rally around a stock which splits, however the market tends to normalize after a short period.
On the downside, stock splits may cause investors to imagine more about how the company performs. If these expectations are not met investor self-confidence may be shaken and the result could be a drop in share prices.
The bottom line is a stock split does not anything to affect the worth or performance of a company. It may be nice to own more shares, although in the end your 2 five-dollar bills are still worth the same as your ten-dollar bill.
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