Updated November 2018
A stock split occurs when a company decides to replace (or “split”) existing shares with multiple shares. For example,
in a two-for-one split, current shareowners will have their shares replaced with two new ones.
Unlike in a share rights issue, where additional shares are released onto the market but the existing shares remain in circulation, current shareholders are not diluted in a stock split. The ownership structure of the company does not change.
In theory, the price should adjust to take account of the split, implying that a two-for-one split of a share trading at 100p should lead to each new share trading at 50p. Stock splits are seen as a bullish sign. Usually companies only split their shares after a period of price appreciation to stop individual shares from becoming too expensive to ordinary investors (which would make them less liquid).
A split is therefore seen as a sign the management is confident the share price will continue to rise. Some traders like to buy shares that have just split, and sell shares that have undergone a reverse split (where a company replaces existing shares with a reduced number of new ones).
The evidence suggests that investors can indeed make money by buying shares that have just split. For example, a 2001 study by David L Ikenberry of Jones Graduate School of Management and Sundaresh Ramnath of the McDonough School of Business found that for American stocks between 1988 and 1998, newly split shares made an average return of around 9% in the year after the division.
The effect is visible outside America, too. A 2006 study by Steven Shuye Wang, Leung Tak Yan and Oliver Meng Rui found a similar result for the Hong Kong stockmarket between 1980 and 2000.