Why Does a Company Split Its Stock?

Why Does a Company Split Its Stock?
Eileen St. Pierre, The Everyday Financial Planner

Photo from www.fansided.com

It was recently reported on Nightly Business Report that Nexflix shareholders will be considering a massive stock split, as high as 30-to-1, at its upcoming annual meeting. Its stock price is currently valued at $647 a share, up almost 90% this year. Why does a company decide to split its stock?

First, here are the basics of a stock split.

The most common type of stock split is a 2-to-1 split. The price of the stock would be cut in half and shares outstanding would double. The market value of the firm of the firm would remain unchanged: MV = Stock Price x # Shares Outstanding.

Netflix currently has 60.62 million shares outstanding. So if Netflix goes ahead with a 30-to-1 stock split, here is what will happen:

  • The stock price would immediately drop 30 times from $647 to $21.57 ($647/30) per share.
  • The number of shares outstanding would increase 30 times to 60.62 million x 30 = 1.82 billion.
  • The market value of the company would remain the same.
  • The company has to have enough capital stock in reserve to undertake a stock split. The shareholders of Netflix need to vote to increase the capital stock reserve.

So if you see a dramatic one-day drop in price on the company’s price chart, don’t freak out and sell your stock (which you shouldn’t do anyway). Check to see if the company had a stock split become effective on that day. It’s the pattern in the stock price before and after the split that is important.

The market considers stock splits as positive signals.

In the first three hours of trading on the day after the NBR report, Nexflix’s stock price jumped about 5.5% to over $683 per share. Stock splits are generally viewed as favorable by the market. Here’s a simple way to look at it:

  • At $683 per share, it would be hard for many investors to afford this stock. If you wanted to purchase a round lot of 100 shares, it would cost you $68,300 plus commission.
  • By cutting the price to about $22 per share, a round lot would only cost you $2,200 plus commission. That’s a big difference.
  • It would give you room in your investment budget to purchase more stocks in order to build a diversified portfolio. Remember, you do not want to put all your eggs in one basket.

A lower price attracts more investors to the stock.

The big run-up in Nexflix’s stock price shows it is a growth stock. By splitting the stock and making it more affordable to a broader range of investors, the management is signaling that they think this growth will continue. Only time will tell if they are right.

For more information on investing, visit my  Basic Financial Management page.