A stock split occurs when a company issues x number of shares for each y number of outstanding shares of common stock without receiving any cash and reduces the par value per share such that there is no change in any component of shareholders' equity.
A stock split effectively ‘splits’ a share of common stock of a company so as to increase the number of shares of common stock without impacting the company’s market capitalization.
Companies typically engage in stock-splits when they believe that their share price is too high. For example, if a company’s stock price is $500, it might be hard for an investor with a $20,000 portfolio to arrive at precise allocation to the stock. Such a company may issue a 10-for-1 stock split to increase its outstanding stock 10-fold and reduce its stock price to $50.
Stock splits are designed by companies keeping in view their intended market price target. If a company wants to reduce its market price by half, it issues a 2-for-1 stock split which involves issuing 1 share per 1 share currently issued. Similarly, a company wanting to reduce its stock price to ⅔ shall issue a 3-for-2 stock split, thereby issuing 3 shares per each 2 shares currently held.
Stock split vs stock dividend
A stock split is like a stock dividend in that both increase the number of shares without any related cash inflow but they differ in how they impact the shareholders’ equity. A stock dividend increases paid-up capital and reduces shareholders equity but most often does not result in any change in par value, but a stock split does not affect any shareholders’ equity account but does change the par value.
Z Ltd. has 2 million 10-par shares of common stock outstanding. The company’s management believes that the current stock price of $300is too high and intends to reduce it to its 1/3.
The company needs to issue a 3-for-1 stock split. This would involve issuing 3 shares for each of the currently issued common shares of the company. It will increase the total number of shares issued and outstanding to 6 million (2 million × 3) but reduce the par value to $3.33 ($10 ÷ 3) and market price to $100 ($300 ÷ 3). The stock-split will not affect balance in any of the shareholders equity accounts.