Stock Split

A stock split is used to reduce the market price of the capital stock of a business in order to make it more attractive to investors. In making the shares more attractive, it is hoped that demand for the shares will rise and its price will increase again to a point where the total market value of the shares after the split is greater than it was before the split.

The process of splitting the stock involves issuing additional shares to current shareholders in proportion to their current shareholding.

Stock Split Example

Suppose a business has 1,000 shares outstanding with a par value of 0.50 per share, and a market price of 95.00 per share. The business feels that the market price of the shares (95.00) is too high and that demand for the shares is falling, and decides to undertake a 2 for 1 stock split to correct the situation.

A two for one stock split means that two new shares are issued for every one currently outstanding. The ratio of the number of shares after the split to the number of shares before the split is termed the stock split ratio, and in the case of a two for one stock split, the ratio is 2/1.

The number of shares after the split is calculated as follows:

Shares before split = 1,000
Shares after split = Shares before split x Stock split ratio
Shares after split = 1,000 x 2/1
Shares after split = 2,000

After the stock split the number of shares outstanding has doubled to 2,000. If each individual shareholder receives shares pro-rata to their current holding, each shareholder will now hold twice as many shares as before the split.

Stock Split – Effect on Market Value

As no cash was involved in the stock split, the total market value before and immediately after the stock split must be the same.

Total market value before split = 1,000 x 95.00 = 95,000

Market value after the split = Total market value / Shares outstanding
Market value after the split = 95,000 / 2,000 = 47.50

The same answer can be found by dividing the current market price of each share by the stock split ratio as follows:

Market price after split = Market price before split / Stock split ratio
Market price after split = 95.00 / (2/1)
Market price after split = 47.50

As a result of the 2 for 1 stock split, the market price of each share has halved from 95.00 to 47.50, this reduction in price will in theory, make the share more attractive to investors and demand should increase.

For an individual shareholder, the total market value of their holding also remains the same. For example, if before the split a shareholder owned 50 shares, then the total market value of their holding was 50 x 95.00 = 4,750. After the split, they own twice as many shares, but each share is now only worth half the market price before the split, and total the market value of their holding is now 100 x 47.50 = 4,750 as before.

Stock Split – Effect on Par Value

The par value of the shares is normally adjusted such that the total par value of the shares before the split is the same as the total par value after the split. The new par value is calculated as follows:

Total par value before split = 1,000 x 0.50 = 500

Par value after the split = Total par value / Shares outstanding
Par value after the split = 500 / 2,000 = 0.25

Again, the same answer can be found by dividing the current par value of each share by the stock split ratio as follows:

Par value after split = Par value before split / Stock split ratio
Par value after split = 0.50 / (2/1)
Par value after split = 0.25

As there has been no change in the total par value, then no stock split journal entry needs to be made in the records of the business.

Memo Entry

A stock split does not require any journal entries in the accounting records as there has been no change in the total equity of the business. A memo entry is normally made to reflect the fact that the split has occurred and that the par value has changed proportionally.

Other Stock Splits

The 2 for 1 stock split is one of the most common forms of stock split, however other forms can be found, examples showing the effect on the number of shares are given below.

3 for 2 stock split
Shares before split = 1,000
Shares after split = Shares before split x Stock split ratio
Shares after split = 1,000 x 3/2
Shares after split = 1,500

3 for 1 stock split
Shares before split = 1,000
Shares after split = Shares before split x Stock split ratio
Shares after split = 1,000 x 3/1
Shares after split = 3,000

5 for 1 stock split
Shares before split = 1,000
Shares after split = Shares before split x Stock split ratio
Shares after split = 1,000 x 5/1
Shares after split = 5,000

1 for 10 reverse stock split
Shares before split = 1,000
Shares after split = Shares before split x Stock split ratio
Shares after split = 1,000 x 1/10
Shares after split = 100

The final example above shows a reverse stock split where the number of shares outstanding is reduced rather than increased. A reverse stock split is used when a business wants to increase the market price of its stock. In this case, the par value of each share would be increased proportionally so that the total par value of the stock remains the same.

Last modified November 6th, 2016 by Team

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