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Why Do Companies Offer Stock Splits?

Zelkadis Elvi
Why Do Companies Offer Stock Splits?

Billionaire investor Warren Buffett is not a fan of company stock splits.

Buffett's stance against stock splits is nothing new. In a 1983 letter to his shareholders, the Berkshire Hathaway CEO wrote: “Splitting the stock would increase that cost (transfer costs), downgrade the quality of our shareholder population, and encourage a market price less consistently related to intrinsic business value. We see no offsetting advantages."

That's why Berkshire Class A stock has never split under Buffett's watch. The stock debuted at $19 in 1965, and now trades for $175,000. The average annual rate of return for those years is around 19%, compared to a 9% S&P 500 return rate. In other words, a $5,000 investment in 1965 is now worth over $29 million. (In 2010, Berkshire split its Class B stock 50-for-1 in order to buy the railroad Burlington Northern (BNSF). The move was not to open up the stock to smaller investors, but to insure that small shareholders of BNSF got the same deal as the big shareholder. It kept anyone who owned under $3,000 of BNSF stock from being forced into a taxable transaction. The Class B stock trades at around $117 per share.)

Related: Could Stock Splits Entice New Equity Investors, Finally?

But not all CEOs agree with Buffett's logic. VF Corporation (VFC), maker of Timberland, North Face and Wrangler apparel, plans to split its stock 4-for-1 next month. The company announced the move after shares topped $200 each.

In this edition of Just Explain It, we’re going to take a look at some of the reasons companies offer for giving stock splits.

Here are just a few of them.

The first argument is that splitting the stock lowers the price -- making the stock more attractive to smaller investors.

Another reason, the stock’s liquidity increases. In other words, if an investor wants to get out of an investment, shares can be more easily traded for cash.

Finally, investors like to see stock splits because it creates a positive image of the company. The market perceives businesses that engage in splits as a growing entity.

Related: Splitsville: Why Big Stock Splits Usually Warn The End Is Near

So what happens when a stock splits? The company’s outstanding shares increase while the price per share decreases. For example, if a company has one million shares issued and they’re trading for $200 each…the company’s total market value is $200 million. If the company offers a 2-for-1 split, the outstanding shares would increase to two million while the price per share would drop to $100.

However, there’s one thing that wouldn’t change…and that’s the company’s total market capitalization. In other words, that company would still be worth $200 million, and the post split value would stay the same.

The most common stock split is 2-for-1, but a company can do anything it wants. In fact, some companies choose to reverse the split. The reverse split is a tactic used by some companies to avoid being delisted from stock exchanges when their share prices fall below the required minimum amount. In 2011, Citigroup Inc. (C) announced a 10-to-1 reverse split -- it would give shareholders one share for every 10 owned.

To calculate the new stock price, divide the previous price by the split ratio. That figure will be the new price per share.

The important thing to remember as an investor is no matter how the company slices and dices its share it doesn’t matter fundamentally. The underlying value of the business doesn’t change a whit.

After all, how can you argue with Warren Buffett? He's consistently among the richest people on earth, with a net worth of $58.5 billion.

What do you think? Give us your feedback in the comments below or on Twitter using #JustExplainIt.