A stock split increases the number of a corporation's issued shares by dividing each existing share.
A stock split happens when a company decides to increase the number of its shares in issue by giving existing investors additional shares for each share that they currently hold. The firm’s share price falls to reflect the enlarged share base and its market capitalisation stays the same. The total value of each investor’s shareholding remains unchanged as well, because they hold the same percentage of the firm after the split that they did before.
For example, assume that a company has 100 million shares in issue and a share price of £50 per share. It carries out a 2:1 (or two-for-one) split, meaning that the investor ends up with two shares for every one they originally had. Then the total number of shares increases to 200 million and the share price falls to £25. The market cap stays at £500m and an investor that previously owned 100 shares worth £1,000 will now have 200 shares worth the same. All financial ratios such as earnings per share and dividends per share will obviously be halved.
It’s widely believed that stock splits improve liquidity, because smaller investors are now more able or willing to trade lower-priced shares. The argument for this is not very compelling: in practice, investors tend to buy or sell a certain value of shares (eg, £5,000) rather than a certain number (eg, 500), so it’s only if the price is very high (eg, £10,000 per share) that you’d expect a lower price to make a difference to how often it’s traded. The empirical evidence is mixed at best; some studies suggest that any change is short-lived and that the bid/ask spread – a more meaningful measure of liquidity than the number of shares that are traded – may get worse after a split.
The opposite of a stock split is a consolidation or reverse split, which happens when a firm reduces the number of shares in issue. These are less common and usually the sign of a company trying to make a very weak share price look better.