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What are stock splits?

A stock split is a simple re-organization of a company's share structure. A company issues a new number of shares for all its existing shares outstanding. The terms two-for-one, three-for-one and five-for-four all describe a different type of stock split.

If a stock has made large gains, the company may want to lower the price of the shares to make the purchase of a board lot (usually 100 shares) more reasonably priced for the average investor. It also tends to make the shares more liquid, which is always a desirable property. Stock splits come in two varieties: one that creates a certain number of whole new shares for the old shares (e.g., two-for-one, three-for-one) and one that creates a fraction of a new share for each old share (e.g., three-for-two, four-for-three). What essentially happens is that the company cancels its existing shares and issues new shares in their place. In a two-for-one split, each issued share is replaced by two new shares. In a three-for-two split, two issued shares are replaced by three new shares (so, in effect, each old share has been replaced by one-and-a-half new shares). It is important to note that stock splits by themselves do not create any value to shareholders. The split is simply a cosmetic change intended mainly to reduce the market price of a company's shares. The immediate effect of a stock split on a company's share price is to reduce it by the proportionate amount of the split. For example, suppose XYZ Corp. declares a two-for-one stock split of its common shares, which are trading prior to the split at $50 per share. You own 100 shares of XYZ, which are worth $5,000. Once the stock split happens, the market, knowing that there are now twice as many shares of XYZ outstanding, will immediately cut XYZ's stock price in half to $25 per share. You now own 200 shares worth $25 each. The net effect is that your investment in XYZ did not change.

After a stock split

Trading Commissions

Depending on the type of brokerage account you have, the commission charge may change. If your broker charges a fee per share, your costs may go up after a stock split, but if you pay a flat fee, a split doesn't affect the cost of trading.

Dividends

When a stock splits two-for-one, the number of shares outstanding doubles and each share is now worth half of the pre-split price. On the same day of the split, the cash dividend the company regularly pays also gets cut in half so the dividend yield remains constant.

Tax Consequences

When an investor receives additional stock from a stock split, there is no tax consequence until the investor decides to liquidate his/her position.

REVERSE STOCK SPLITS

Reverse splits occur most frequently among lower-priced junior mining and oil exploration companies. A reverse split raises the market price of the new shares and can put the company in a better position to raise capital. The company substitutes one share of stock for a predetermined amount of shares but, again, the value of investor holdings remains the same. Example: ABC Corporation has shares selling at $1.00 per share and declares a one-for-four reverse stock split. After the reverse split, there will be 1/4 as many shares outstanding and the stock will now have a market price of $4.00 per share. If an investor owned 1,000 shares of ABC Corporation before the split at $1.00 per share, he will now own 250 shares at $4.00 per share.

Tip - Hold on!

The benefits of long-term investing often comes into play when it comes to stock splits. When a company splits its stock, it often reflects solid growth and earnings potential. If the company continues to grow rapidly, the additional shares increase the value of an investor's portfolio.

In order to fully understand the implications of stock splits on your long-term portfolio, it is important to discuss the tax implications and treatment of capital gains with your financial planner or accountant.