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Reviewing the Basics of a Stock Split
Monday December 31, 11:55 am ET
By Jeff Neal


When companies announce a stock split, it can act sometimes as a tremendous catalyst that causes the underlying stock to gain momentum. For that reason alone it is certainly useful to understand the stock split process. To do this, it is important to know the requirements before a stock may split as well as the general profile of a company that may decide to announce a split of their stock.

First we need to be clear about what a stock split really entails. A stock split is a division of corporate stock by the issuance to existing shareholders of a specified number of new shares with a corresponding lower of the market value of each outstanding share. This of course is opposed to an actual stock dividend, which is usually a payment by a corporation of its own stock without a change in the market value of the underlying asset.

Typically, before a corporation, along with their board of directors, decides to split, the stock needs to be in a strong uptrend and also have a comfortable anticipation that the stock will continue the trend. Naturally, the company must have enough unissued authorized shares to split the stock, and then the board of directors must meet and declare a stock split.

If authorized shares need to be added, then the corporation must seek approval from shareholders, which requires a shareholder meeting for a vote to support additional shares being issued. At that point the company can announce the stock split and both the split and recording dates are set. When the split date does indeed arrive, additional shares are issued and the stock price per share is adjusted accordingly.

In addition, a stock split announcement is typically accompanied by another major event—for example, a dividend being paid, expansion plans, a stock buyback program or even changes to management. More often than not, when a company declares a stock split, it means that particular firm is experiencing success.

The average profile of a company that declares a stock split is that they are currently operating with increasing revenue and net earnings, as well as expanding operating margins. Typically the stock price is close to or higher than the price of the last split, is in a general uptrend, and, of course, is expected to continue to climb. In addition, business is forecasted to be very good going forward, shareholder confidence is high, and basically no major legal issues are pending reconciliation.

Historically, some of the reasons not to split include a chance of future revenues decreasing below expectations and that future earnings could consequently suffer. Also, the company could be operating in a particular sector that could face difficulties, or the company is about to execute an acquisition or merger where a stock split would have a negative impact.

Stock splits are certainly worth monitoring and when correctly identified provide excellent candidates for low-risk and high-reward options strategies. In fact, if you can see a stock split coming while implied volatility is very low, the situation has a tremendous chance of being highly profitable when coupled with the appropriate options strategy.