We've been sorting through questions in advance of our upcoming "Ask TheStreet" column, and one recurring query we've noticed is whether a stock split is -- as Martha Stewart would say -- a good thing.
In our reply, we ask a question of our own: Would you rather have a single $100 bill, or a pair of $50 bills?
No, it's not a trick question. It's the same thing.
Well, that same logic applies when it comes to stock splits.
When a company's stock price gets very high, some investors may shy away from purchasing it. In an effort to lure investors with a lower price tag, companies often split their stock in two or more equal parts. For example, if XYZ Co.'s stock climbs to $120, the company may announce a 3-for-1 stock split, meaning shareholders would get three $40 shares for every $120 share they hold. The underlying value remains the same.
In essence, the "six of one, half dozen of the other" model holds true. But investor sentiment often makes it seem different. Some investors, for example, may like to purchase shares in 50-share or 100-share lots, and a big price tag for one stock may keep them away. A stock split gives these smaller investors a psychological boost to buy the stock.
Consider the case of star investor Warren Buffett's company,
. Buffett has never split his stock, which is why Berkshire's shares trade at close to $90,000 each. If the so-called "Oracle of Omaha" ever decided to split his stock, it would increase the opportunity for millions of smaller investors to finally buy a piece of Berkshire. The ensuing rush to buy the stock could very well cause a temporary spike in the price, but remember, it wouldn't change the value of the company.
Many investors will monitor stock-split announcements, hoping that smaller investors, like in the Berkshire example, will pile in -- and allow them to quickly sell the stock at a profit.
Now that you understand the truth about stock splits, though, you won't give them that chance again.
Since the bursting of the tech stock bubble, many companies have chosen to do reverse stock splits -- splitting a stock 1 for 5, for example -- to raise the price to a level that might be more enticing to institutional investors.
The most prominent recent example is
, which announced its reverse split plans late last year. With JDSU shares stuck below $2, the company said it needed to consolidate the share base to move into a price range more attractive to institutions. Many big mutual funds and other investors are prohibited from buying stocks that trade for a dollar or two.
The optical networking parts maker has 1.6 billion shares outstanding and traded recently at $2.84. Shareholders have approved the plan, which calls for a 1-for-8 or 1-for-10 reverse split, but the company hasn't put it into effect yet. As a result of the reverse split, the company could reduce its share count to about 160 million, presumably bumping the share price into the midteens. JDSU hasn't traded there since the tech bubble popped several years ago. The stock fetched as much as $124.48 back in August 2000.
On the negative side, many companies engage in a reverse stock split as a last-ditch effort to keep their stock price above $1, the minimum value to maintain a listing on the
. But as we learned from a regular stock split, the move is entirely cosmetic and has no bearing on the underlying business.
Some investors even warn that reverse splits can easily invite more stock drops. This is particularly true if the company's fundamentals are deteriorating and the new, higher price starts looking like a fat target for short-sellers, who bet on a stock's decline.
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