There were few things that got traders hearts pounding during the internet bubble more than stock splits. Even the mere rumor that a company was going to split its share sent some stocks up by 20% or more. It seems that investors became excited at the prospect of owning two $50 bills instead of a single $100 bill.

What Exactly is A Split?

A stock split is an action that increases the number of a corporation's outstanding shares by dividing each share according to a set ratio, which in turn diminishes its price. The stock's market capitalization, however, remains the same, just like the value of the $100 bill does not change if it is exchanged for two $50s. For example, with a 2-for-1 stock split, each stockholder receives an additional share for each share held, but the value of each share is reduced by half: two shares now equal the original value of one share before the split.

A More Detailed Example

Assume stock XYZ is trading at $40 and has 10 million shares issued, which gives it a market capitalization of $400 million ($40 x 10 million shares). The company then decides to implement a 2-for-1 stock split. For each share shareholders currently own, they receive one share, deposited directly into their brokerage account. They now have two shares for each one previously held, but the price of the stock is split by 50%, from $40 to $20. Notice that the market capitalization stays the same - it has doubled the amount of shares outstanding to 20 million while simultaneously reducing the stock price by 50% to $20 for a capitalization of $400 million. The true value of the company hasn't changed at all.

The most common stock splits are, 2-for-1, 3-for-2 and 3-for-1. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. In the case of our example, divide $40 by 2 and we get the new trading price of $20. If a stock were to split 3-for-2, we'd do the same thing: 40/(3/2) = 40/1.5 = $26.6.

So Why Split?

What is the point of a company splitting its shares then? It is certainly not an essential activity as Warren Buffett can attest to. (His companys stock, Berkshire Hathaway, is trading above $90,000 per share.) However, stock splits can be a psychological positive. As the price of a stock increases, 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 true value of the stock doesn't change one bit, but the lower stock price may affect the way the stock is perceived and therefore entice new investors.

Beware Excessive Splitting

Sometimes companies go overboard with their stock splits. During the bubble days, some of the internet stocks like CMGI and JDS Uniphase split their shares multiple times during one year. This generated strong investor enthusiasm and got the Yahoo! message boards buzzing, but it may have actually harmed the stocks in the long run.

When stocks split too much, they increase their float, or available shares to trade according to the ratio of the split. This improves liquidity to a point, but it also makes it harder for the stock to increase as more demand is needed to sop up the additional supply. One of the reasons internet stocks went up so much was the fact that they had tiny floats, which caused the stock to explode when there was buying pressure.

Be on the lookout as to how many times a stock has recently split. If it seems obvious that management splits its stock excessively, avoid it. More than twice a year should raise some suspicion, or at least warrant some deeper research into the story.