Stock splits are distinct from stock dividends and involve an exchange of multiple shares of stock for existing outstanding shares. In a two-for-one stock split, for example, each “old” share held by existing shareholders can be exchanged for two “new” shares. Unlike stock dividends, stock splits usually do not entail a reduction in retained earnings nor an increase in paid-in capital. In fact, stock splits usually do not change any of the elements in the financial statements. Only the description of the firm’s stock is amended to reflect the new number of shares authorized, issued, and outstanding.
Managers may split a firm’s stock when they believe that the price per share has risen beyond the range that is attractive to smaller investors. Therefore, splitting the shares is expected to reduce the share price and increase demand. Similar to stock dividends, stock splits also seem to be interpreted by investors as favorable signals by management about future operating performance. Stock splits usually result in an increase in the total market value of the firm’s outstanding shares because the price per share typically does not decline sufficiently to offset the increase in the number of shares. For example, a two-for-one stock split usually does not cut the price per share in half.
Case study 9.1 shows how a stock split is reported by one major corporation.
Case Study 9.1
A footnote to the 1997 financial statements of Du Pont Company includes the following information:
The company’s common stock was split two-for-one effective May 15, 1997; all per-share data and common stock information have been restated to reflect this split.
a. Why does Du Pont give retroactive recognition to the stock split in all related financial statement references?
b. Why do you suppose Du Pont’s management decided to split the company’s stock?
c. As an existing Du Pont shareholder, would you be pleased by management’s decision to split your stock? Explain.
a. Du Pont gives retroactive recognition to the stock split in order to aid analysts in making comparisons with prior years. For example, if net income is unchanged from the prior year and the number of shares is not retroactively adjusted, the earnings per share would appear to decrease by 50 percent.
b. The company may have split the stock in order to reduce the per-share price, thereby making the stock more accessible for smaller investors. Alternatively, management may use stock splits as an indirect way to signal investors that management expects higher per share earnings and dividends in the future.
c. Generally, existing shareholders benefit from stock splits. Although each shareholder’s fractional interest in Du Pont is not changed by the stock split, the total value of existing shares usually increases around the date of such announcements. The increase in stock prices may reflect investor expectations of higher future cash flows.