Image source: Getty Images.
Continue Reading Below
There are many ways you can slice a pie and many reasons why you might want to serve larger or smaller pieces. But go too big, and the size of a piece can become overwhelming. Sometimes, the same could be said of stocks.
When a stock price gets high, sometimes a public company will want to lower that price. How? With a stock split.
A stock split is a decision by acompany's boardto increase the number of outstanding shares in the company by issuing new shares to existing shareholders in a set proportion. Stock splits come in multiple forms, but the most common are 2-for-1, 3-for-2, and 3-for-1 splits.
Let's say you owned 10 shares of a stock trading at $100. In a 2-for-1 split, the company would give you two shares with a market-adjusted worth of $50 for every one share you own, leaving you with 20 shares. Or, in a 3-for-2 split, the company would give you three shares with a market-adjusted worth of about $66.67 in exchange for two existing $100 shares, leaving you with 15 shares.
Keep in mind that while you now have more shares than you started with, the total value of those shares is the same as it was before the split: $1,000. And while the company's shares outstanding increase with the split, its market capitalization -- that is, the total value of the company derived from multiplying the number of shares by the stock price -- remains the same, too.
Continue Reading Below
Stock splits were more popular in the 1980s and 1990s, but they've been less common in recent years. In 2015, there were just 12 stock splits among companies in the S&P 500, according to Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. Compare that to the 102 stock splits among S&P 500 companies in 1997.
Why would a company want to do a stock split, and why are we seeing fewer of them these days?
Historically, brokerage firms would charge more for trading "odd lots" -- that is, transactions in any increment other than 100 shares. That means it would be more expensive to trade 10 shares than it would be to trade 100 or 200 shares.
As such, companies would split their shares to ensure the price of an "even lot" of shares didn't grow too big. After all, far more investors are likely to be able to afford to invest in 100 shares priced at $10 a share than in 100 shares priced at $100 a share.
Today, however, online brokerages typically charge the same commissions regardless of how many shares are purchased, eliminating one compelling reason for stock splits.
Some argue that these days some companies might actually value the prestige of having a high stock price -- especially when a stock split can involve administrative and registration costs that a company might want to avoid.
Still, there are other reasons a company may split its shares. While there is no longer a higher price for trading an "odd lot" of shares, a psychological barrier may remain around trading high-priced shares. And high-priced shares may simply price out those with less cash to invest.
When Apple Inc. announced a 7-for-1 stock split in 2014, when its shares traded at about $645 a share just before the split, Apple CEO Tim Cook said, "We are taking this action to make Apple stock more accessible to a larger number of investors."
Meanwhile, a company with a very low stock price might engage in the opposite behavior: a reverse stock split, to increase its per-share price.
Let's say a company's shares were trading at $1. Shareholders might receive one share for every five old shares. The new shares would be priced at $5.
Companies may do reverse splits to maintain their listing on a stock market that has a minimum per-share price. Or a company might want to appeal to certaininstitutional investorswho may not buy stock priced below a certain amount.
Regardless, if a company announces a reverse split or it actually takes place, you will want to proceed with caution.
"Reverse splits tend to go hand in hand with low priced, high risk stocks," FINRAhas warnedinvestors.
At the end of the day, it's important to remember a stock split -- or a reverse stock split -- does nothing to change the value of a company. How a stock performs in the long run will depend on multiple factors, not on how its shares are split.
10 stocks we like better thanWal-Mart
When investing geniuses David and TomGardner have a stock tip, it can pay to listen. After all, the newsletter theyhave run for over a decade, the Motley Fool Stock Advisor, has tripled the market.*
David and Tomjust revealed what they believe are theten best stocksfor investors to buy right now... and Wal-Mart wasn't one of them! That's right -- theythink these 10 stocks are even better buys.
Click hereto learn about these picks!
*StockAdvisor returns as of December 12, 2016
The author(s) may have a position in any stocks mentioned.
The Motley Fool has a disclosure policy.