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Usually, companies authorize stock splits in the hope that cheaper shares will lead to
increased investor interest. A company may also authorize a split in a move to increase
liquidity, reduce volatility and broaden its shareholder base, thereby diminishing the
chances of a hostile takeover.
A stock split increases the amount of shares that exist, but does not change the value of an investor's holdings or the market value of the company. For instance, one share worth $100 becomes two shares worth $50 each in a 2-for-1 stock split. Splits can occur in any combination: 2-for-1, 3-for-2, 5-for-3, etc.
Because stock splits have no impact on the fundamentals of a company, the interest garnered by stock splits is generally considered strictly psychological. A stock split technically doesn't mean a thing, but investors prefer to buy a stock at $30, rather than $60.
Years ago, that reason was more substantive. Brokers were once fined for purchasing "odd lots" -- less than 100 shares -- of a certain stock and splits enabled smaller investors to buy "round lots" they previously may have been unable to afford. Now, those penalties have long been eliminated.
Meanwhile, some research does seem to indicate a positive correlation between stock splits and stock prices.
A study of the performance of 2,750 companies from 1975 to 1990 conducted by Rice University professor David Ikenberry found that shares climbed, on average, about 3.4 percent in the days immediately following a stock split.
More significantly, the study found that over a three year period, shares that were split outperformed comparable issues by about 8 percentage points the following year, almost 9 percentage points the second year, and 12 percentage points the third year.
Those figures indicate some long-term investment significance can be gleaned from stock splits. Stock splits in and of themselves have no redeeming economic value, but they do contain information. That is, companies don't just randomly split their shares. They tend to do it when they are optimistic about where the company is headed.
In addition, the strong performance of the stocks that split could be related to the fact that companies which split tend to be among the fastest growing firms to begin with.
So what is an investor to do? The key is to see a stock split as a tip-off and then seek out additional clues. For one, make sure the company that is splitting has "honorable" intentions. Companies that have major stock incentive plans, for example, may use stock splits to bolster their management's compensation packages. Others may be trying to raise funds to pay off debt.
In addition, if a stock price has been fairly flat in the month preceding the split or is just generally low -- below $45 -- proceed with caution. Stagnant or low earnings and growth rates are other warning signs.
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