People have been trying to emulate Warren Buffett's investing style for decades. A lucky few don't have to worry about that because they own shares of Berkshire Hathaway, so he is essentially working for them. At over $3000 a share, however, putting Mr. Buffett on your payroll was a distant dream for most. So, when Warren Buffett announced a stock split, individual investors became very excited. This meant that shares of Berkshire Hathaway would be affordable for the first time since the Oracle from Omaha started managing Berkshire. We'll look at the magic of stock splits and whether they mark a good time to buy or a good time to say goodbye.
 
What Are They?

A stock split, as the name implies, is essentially the division of the outstanding shares of a company into a greater number of shares. A stock split does not change either the proportional ownership of shareholders in the company or its total shareholders' equity. While a stock split may be done in any ratio at the discretion of the company's Board of Directors, a 2-for-1 (or 2:1) stock split is the most common one, and involves the issuance of one additional share for every outstanding share of the company.

Stocks splits are significant corporate actions that need the prior approval of the company's Board of Directors and its shareholders.

A Sample Split

Consider a company that has 100 million shares outstanding and declares a 2-for-1 split. If the shares are trading at $50 just prior to the split, they will theoretically trade at $25 on the date that the split become effective (called the "ex-split" date). Although the company's outstanding shares will now double to 200 million, its market value or capitalization of $5 billion (i.e. $25 x 200 million) will be unchanged. Likewise, a shareholder who held 1,000 shares before the split, will now own 2,000 shares after the split, but the total value of the shareholder’s holding will be unchanged at $50,000.

Reasons To Split Up

If this action has no discernible effect on shareholders' equity or their proportional ownership, then why do companies expend time and money to split their shares? There are good reasons for stock splits and reverse splits.

Attracting The Small Investor

A stock split is a normal stage in the evolution of a profitable company. A growing company that is increasing revenues and profits will see its stock price appreciate over time, to the point where the price may be considered to be too high for the average retail investor. A stock split brings the share price down to a price where a typical retail investor can afford to buy at least 100 shares. Most investors prefer to buy at least 100 shares of a company because the brokerage commission on buying an odd lot of less than 100 shares is higher on a percentage basis - however, this is only a marginal consideration with the advent of flat rate commissions.

Liquid And Cheap

A stock split, by virtue of increasing the number of shares outstanding, also has the effect of increasing its liquidity. Additionally, a stock split is likely to broaden a company’s investor base because the lower price may attract a larger number of investors.

A stock split is usually viewed bullishly by investors, and the stock's price and trading volume may initially increase as more investors are drawn into the fold when the split occurs. The effects of a stock split fade away quite rapidly, however, as investors turn their attention once again to the company's fundamentals.

In the 1990s, many technology companies routinely split their stocks as they soared and took the Nasdaq Composite index to record heights. But as the boom turned to bust and the Nasdaq index plunged more than 75% during the 2000-02 bear market, stock splits became a thing of the past. Some technology companies even had to resort to reverse splits.

Buffet Doing The Splits

In January 2010, Class B shares of Berkshire Hathaway – the holding company owned by legendary investor Warren Buffett – underwent a 50-for-1 split, bringing the stock price down from about $3,500 to approximately $70. The stock split was not undertaken merely to attract a bigger retail investor following. Warren Buffett was not concerned with attracting retail investors. Berkshire Hathaway's Class A shares trade in the low six figures, and the Class B shares were only introduced in 1996. Rather, Berkshire Hathaway said that the stock split was needed to facilitate its acquisition of railroad company Burlington Northern Santa Fe. The split allows even small holders of Burlington shares to exchange them for Berkshire Hathaway shares if they prefer the latter to cash.

The Bottom Line

Stock splits are akin to optical illusions – they give the impression that things have changed. In reality, splits are only adjustments in the number of shares outstanding, while the company's equity and the value of shareholders' holdings remain unchanged. Although most investors view stock splits as inherently bullish, do not be swayed by this fact alone. The effects of stocks splits are only temporary in nature. Ultimately, the company's business fundamentals will be the true drivers of the stock's value and its future direction.

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