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 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
To illustrate suppose a business has 1,000 shares outstanding with a par value of 0.50 per share. Additionally the market price of each share is 95.00. The business feels that the market price of the shares (95.00) is too high. Consequently, as demand for the shares is falling, it decides to correct the situation with a 2 for 1 split.
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. In this example of a two for one 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.
Effect of Split on Market Value
As no cash was involved in the stock split, the total market value before and immediately after the 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 split ratio.
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 is calculated as follows.
Market value of holding = Number of shares x Market value per share Market value of holding = 50 x 95.00 = 4,750
After the split they own twice as many shares. However, each share is now only worth half the market price it was before the split. The total market value of their holding is now as follows.
Market value of holding = Number of shares x Market value per share Market value of holding = 100 x 47.50 = 4,750
It is important to realize that the market value of the holding has not changed.
Effect of Split 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.
Stock Split Journal 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 number of shares and the par value of each share has changed proportionally.
Other Stock Splits
The 2 for 1 stock split is one of the most common forms of split, however other forms are available. Examples showing the effect on the number of shares for various splits 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 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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.