What We Know about Stock Splits

By Rudd, Lauren | Sarasota Herald Tribune, April 5, 2015 | Go to article overview

What We Know about Stock Splits


Rudd, Lauren, Sarasota Herald Tribune


Many investors relish the idea of a stock split, and why not? The shares you hold are instantly multiplied by some factor. Furthermore, stock splits often occur after a respectable series of earnings reports and a continual rise in the price of a company's shares. Of course dividing a pie in four pieces or eight pieces does not increase the size of the pie. However, if you feel wealthier after a stock split, do not worry; you are not alone.

After a split the lower price results in a cosmetically more affordable product that hopefully will lead to increased investor interest combined with an upward price spiral. However, there is no guarantee that the newly lowered price will entice continued or increased demand for the shares.

The daily price of a share is dependent on laws of supply and demand. Any presumed overabundance of shares, whatever the reason including splits, could overwhelm demand and be viewed as a bearish indicator.

Stock splits will also have a detrimental effect on indexes, such as the Dow Jones industrial average, which is a simple average of the share prices within the index. As a result, whenever one of the 30 stocks that comprise the Dow splits, the index becomes slightly more volatile. To understand why, consider the following.

The Dow, first developed by Charles Dow in 1884, is a superficial indicator that does not depict the subtleties of the stock market. It is simply an arithmetic average of 30 stock prices. There is no weighting to account for a company's market capitalization.

This means you add up the prices and divided by 30. Obviously, the higher priced shares will have a disproportional effect on the overall average. This is one reason Apple had to split its shares prior to being considered for membership in the Dow 30.

The problem arises when a company within a price weighted average, such as the Dow, splits its stock. If some adjustment is not made, the Dow will suddenly fall due to the lower price resulting from the stock split. Therefore, the solution is to tinker with the divisor.

To neutralize the effect of splits, the divisor is lowered each time a stock split takes place within the index. The divisor is also adjusted when one stock replaces another. …

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