A couple of weeks back, I explained what a share of stock represents. Today, I am going to explain another complicated investment scenario: stock splits.
Stock Prices Rise and Fall
This is not news to any of you, but stock prices rise and fall over time. Those increases and decreases generally correspond to company performance and the overall economy.
Savvy investors use technical and fundamental analysis to decide when to buy and sell stock.
Over time, if a company does very well, its stock will rise, and continue to rise. If it does poorly, the price will fall. If it falls to low, the company risks being delisted from major exchanges or being bought by another company.
When Prices Get too High
Some companies like having high stock prices. Tech giants Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) both have prices well over $500. Berkshire Hathaway (NYSE:BRK.A) (disclaimer, I own Berkshire Hathaway Class B Shares) has an A share price over $150,000.
Most companies, though, prefer to have more liquidity in their shares. When a stock is well over $100, many investors may erroneously believe the stock is “expensive” or not be able to afford to buy it in their portfolio.
To increase liquidity and promote higher trading volumes, companies may engage in a stock split. For example, if a company stock is $100 per share, they may split 3:1. Afterward, there are three times the number of shares at 1/3 the price. If you own 10 shares at $100 each, after the split you own 30 shares at $33.33 each. Your total investment has the same value, but it may now be easier to sell your shares quickly or accumulate a round lot (a traditional investment of 100 shares).
When Prices Get too Low
If a company’s share price is below $1 for a length of time, the major exchanges will de-list the stock. That is bad for a public company, so a company may go through a reverse split to raise the stock price.
Recently, Massachusetts based NeuroMetrix (NASDAQ: NURO) was threatened with delisting. The 1:6 reverse split took place on February 19th and, as of the closing price on February 15th, took the stock from $0.4776 per share to $2.87 per share.
Reverse splits are looked down upon by the investment community. It shows that a stock has performed poorly and the management does not believe it is able to raise the price back up with business performance.
My Big Stock Split – Investors Can Be Stupid
According to fundamental analysis, a company has an intrinsic value. Divide that value by the number of shares, and you have a target stock price. A split does not change the intrinsic value of the company and should not lead to a change in market cap. But sometimes it does.
I knew that when Berkshire Hathaway B shares split 50:1, a lot of people that couldn’t afford it at $3,500 per share would want to get a piece of Warren Buffet’s company at $70 per share. While the value of the company would not increase, the demand for the shares would.
I was right. If you look at a stock chart for BRK.B from early 2010, the stock took a huge jump when it split, making me and other astute investors quite a bit of money. (I wish I had kept more than 10 shares!)
Not all split stories work like this, however, so be careful speculating on the future share price after a split or reverse split.
Questions and Stories
Have your stocks ever split or reverse split, what happened to the market cap after the change? Any other questions? Let me know all in the comments.
Originally published January 19, 2009. Updated February 20, 2013. Image by Tulane Public Relations / flickr.
Eric
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