Stock splits present one of the most misunderstood aspects of the stock market. Psychologically stock splits feel like you have gained value, but in reality you just own twice as much paper. Much the same as if you changed a ten-dollar bill for two five-dollar bills. Once a stock splits 2-for-1 you have twice as many pieces of paper (shares) as you did before. But your shares still represents the same percentage of the total outstanding shares of the company as it did before.

Investor psychology motivates the issuing company to do this. Stocks are generally sold in lots of 100. When a stock splits it’s more likely to the needs of a small investor. For instance suppose a stock is selling for $60 a share. A lot of 100 shares would cost $600. If this stock splits 3-for 1, the price of a share goes from $60 to $20; and the cost to 100 shares goes from $600 to $200. Suppose a small investor has $400 he would like to invest. A hundred shares for $600.00 is out of his reach, but 200 shares for $400.00 meets his needs exactly.

Although there are many ratios a stock could split, the most common splits are 2-for-1, 3-for-2, and 3-for-1. Also possible is a reverse split where a company reduces the outstanding shares. A reverse split results in each holder being issued less shares than before. A reverse split gives you less paper but you still own the same percentage of the company. One reason a company might decide to do a reverse split is that price per share is so small it looks like a poor investment. If the price of a share becomes too low it might get de-listed by the stock exchange. Other reasons for a reverse split could be to push out minority stockholders, or as a way to go private.

The biggest advantages of a stock split is greater liquidity. As mentioned before stocks are sold in lots of a hundred. So the lower the price of the stock, the more likely they will meet the criteria of a small investor’s budget. The bid/ask spread is the difference between buying and selling prices. Typically the smaller the price of a stock the smaller the bid/ask spread. A high bid/ask spread can put off larger investors. Psychologically, a split is perceived as bullishness. The spit is seen as a sign that the company is doing well. A stock split generally sets off a short-term rally, although the market usually normalizes shortly.

Stock splitting is one of the best things that can happen to an investor. When a stock splits, then the stockholders would receive twice as many shares as before. Though the volume of the shares would almost double, the value of each share would be reduced. It’s something like getting two five-dollar bills in place of a single ten-dollar bill. The value would remain the same, but the bulk of paper would become twofold.

Sometimes an investor may feel a stock to be quite beyond his/her reach due to the high price per share of the stock. But when the stock splits, then the reduced value becomes much more affordable to the smaller investors. A $100 share could seem to be too much to invest in, but if it is split two-way, then the $50 stock would seem to be more affordable. This is the reason why companies go ahead and split their stocks. It plays favorably on the psychologies of their investors and they build on more capital.

There are a number of ways in which companies split their stocks. The most common ones are two-for-one, three-for-two and three-for-one. There can also be a reverse splitting of the stocks; i.e. reducing the number of outstanding shares so that each company has fewer shares than before. Such reverse splitting is very uncommon, but it may be used if the company feels that the price per share is so low that it reflects as a bad investment to their investors. A very low share value could also entail delisting from the stock exchange, or it may simply be a way of the company to go private.

Due to the lower prices, the companies build up more liquidity by splitting their stocks. Lower prices mean more possibility of selling the stocks since the investors could place them better within their budgets to buy them. However, high share prices could be intimidating to the investors.

One more advantage of stock splitting is that it is perceived as an indicator of a bullish market. If the stock prices are increasing, it might mean that the company is doing well financially. The rally around the stock could last for a short time after the splitting, but generally it pulls itself back to normal quite fast.

But a stock splitting could also cause the investors to raise their hopes about the company’s potentials. Therefore the company would need to live up to the standards the investors have come to expect, or they risk losing investor confidence.