Definition: A stock split, also called a forward stock split, occurs when a corporation recalls its outstanding shares and issues more than one share for each previously outstanding share. In other words, the corporation takes the outstanding shares the shareholders owned, and splits them into a larger number of shares still maintaining the same total value.
What Does Stock Split Mean?
Since additional shares are issued, both the par / stated value and the market value are decreased by the multiple of newly issued stock. You can think of this like cutting an apple in half. After the apple is split in half, you have two pieces of apple, but it’s still worth the same amount as one whole apple. You just have two smaller pieces of apple now. A reverse stock split will have the opposite effect. This concept might be easier to understand with an example.
Big Al Corp. has 1,000 $5 par value shares outstanding at the beginning of the year. This is Big Al’s fourth year of high profits and as a result, its market value per share has increased from $10 per share to $500 per share. Fearing that the high stock price will scare off new investors, Big Al decides to do a 1-for-5 stock split to reduce the market value of it’s shares.
The one-for-five split recalls the original shares and replaces each share with 5 shares. Thus, after the split, Big Al Corp. will have 5,000 $1 par shares outstanding. The market price will also be reduced by the split multiple of five resulting in a new market value of $100 per share. There is no journal entry required to record a stock split since no change in equity actually occurred.
So on the owner level, each shareholder would own five times more shares after the split than before the split, but the total value would still be the same. A person who owned one $500 share before the split would now have five $100 shares after the split.
Stock splits typically require approval by both the shareholders and the board of directors and are made for a variety of reasons. The most common reasons include making shares more affordable, getting rid of uneven holding amounts, and establishing an issuance price.