Tricks Of The Trade

Doing The Splits

There's almost nothing investors love more than to hear that their stock is splitting. Having more shares makes you feel like you have more money. But like a peek into the fun house mirror, all is not as it appears. Stock splits are actually a form of the lowly dividend. Here's how they work: Say you own 100 shares of XYZ corporation whose price per share is currently $50. If it splits two for one, you suddenly have 200 shares at a price of $25 per share. No matter how you cut it, the value of your investment is the same: $5,000. Perhaps it's the loaves and fishes concept that makes stock splits so attractive--where there once was one, now there are more.

On the other hand, stock splits can perform several useful functions, often increasing a stock's liquidity and dropping the share price to a level where small investors can participate. Many small investors who can't afford stocks trading at $100-plus prices wait for big-ticket stocks to split. Though splits are normally just a mathematical affair, pent-up demand could cause post-split prices to climb higher.

Bull markets often mean more splits. Since October 1990, nearly half the companies listed in the Standard & Poor's (S&P) 500 index have split their stock. In 1996, 166 New York Stock Exchange (NYSE)-listed companies split their shares, up 26 percent from the previous year. The record for stock splits was set in 1983, when 225 NYSE-listed companies split their stocks.

Splits have also seen positive market reaction because they often signal that a company's management is positive about its future. While past performance is no guarantee of future results, stock splits are often used as a measure of market performance. Prudential Securities research found that nine of the 14 companies in the S&P 100 index that split their stocks in 1996 have outperformed the index, which rose more than 22 percent, by an average of 8.38 percent.

Should you buy before or after the split? Often, the price of shares will dip right after a split as investors sell shares to diversify. In the long term, stock splits are rewards given to longtime shareholders, so if you own a stock that splits, you should hang on to it.

There is also more than one type of split. The reverse split is used by companies whose share price is very low. The number of shares outstanding is decreased and the price of shares increased. This is done to attract investors who wouldn't think of buying a stock selling at $2 per share but who might buy shares selling at $20 each.

To find out which stocks are splitting, check Barron's financial newspaper or consult your financial advisor.

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This article was originally published in the March 1998 print edition of Entrepreneur with the headline: Tricks Of The Trade.

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