Question

Finance theory proves that stock dividends and stock splits are beneficial to the shareholders in the long run.

Discuss how and why exchanging 1 share at $60 for 3 shares at $20 each can be beneficial to the shareholders.

Answer 1

Companies split their stock to make it look more affordable to smaller investors, thereby broadening their investor base. If a company’s share price climbs into the hundreds or thousands of dollars per share, the stratospheric price may deter investors who don’t see much more upside potential or who simply can’t afford the price. The reduced stock price, because of the split, may make the stock look more attractive despite the larger pool of shares. If the more-affordable price excites investor interest, they’ll drive up the market price per share, enriching those who already own the stock. Many investors view a stock split as a positive signal by management that the company’s future prospects look good and bid up the shares accordingly.

In theory, a split should result in an increase in the number of shareholders as more investors would buy at lower prices.

However, the key parameter to be evaluated while investing in a company that has gone for a stock split is the valuations of the company or the underlying fundamentals.

Perhaps the most compelling reason for a company to split its stock is that it tends to boost share prices. A Nasdaq study that analyzed stock splits by large-cap companies from 2012 to 2018 found that simply announcing a stock split increased the share price by an average of 2.5%. In addition, a stock that had split outperformed the market by an average of 4.8% over one year.