A stock split shouldn’t actually matter in terms of valuing a company, but for some reason they do. A stock split is when a company divides its stock (often you’ll see 2 for 1 or 10 for 1 stock splits) to shareholders on a date certain. For example, MasterCard announced a 10 for 1 stock split recently which provides that shareholders as of January 9 will get 10 shares for every 1 share they own on that day on January 21.
Why Shouldn’t a Stock Split Matter?
Imagine you have a pie (mmmm pie) that was split into 4 pieces and you own 25% of it. Now the pie gods say I am taking that same exact pie and splitting it into 8 pieces but you are getting 2 pieces (i.e. still that same 25%). Did anything really change? No you have the same amount of pie goodness in your life.
To continue the implied metaphor…the pie is the company (mind blown like the first time you saw Fight Club?). So on January 20, 2014 if your 1 share of MasterCard was worth .000000000000001% of the company on January 21, 2013 your 10 shares will still be worth .000000000000001% of the company. So for the retail investor nothing is supposed to change.
Why Does a Stock Split Matter?
Investopedia provides some very good reasons why a stock split does change things:
- The first reason is psychology. As the price of a stock gets higher and higher, some investors may feel the price is too high for them to buy, or small investors may feel it is unaffordable. Splitting the stock brings the share price down to a more “attractive” level. The effect here is purely psychological. (Editor’s note: As discussed above)
- Another reason, and arguably a more logical one, for splitting a stock is to increase a stock’s liquidity, which increases with the stock’s number of outstanding shares. When stocks get into the hundreds of dollars per share, very large bid/ask spreads can result.
Lastly, there is a discussion of whether it affects those that might be charged on a per share basis for trades. This doesn’t affect most retail investors, but depending if you are for or against high frequency trading there is a pro/con. It would take HFT more shares to move the same amount of capital, and as such, it could increase their trading costs a bit. Again, this has little to do with 92% of retail investors.
While I believe it to be a purely psychological…it doesn’t matter if there is empirical proof that the shares continue to rise thereafter making those that make those decisions wealthier.