Splits and Buybacks Explained

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A corporation whose stock is performing well may opt to split its shares, distributing additional shares to existing shareholders. The most common split is two-for-one, in which each share becomes two shares. The price per share immediately adjusts to reflect the change, since buyers and sellers of the stock all know about the split (in this case, it would be cut in half). A company will usually decide to split its stock if the price of the stock gets very high. High stock prices are problematic for companies because they make it seem as though the stock is too expensive. By splitting a stock, companies hope to make their equity more attractive, especially to those investors that could not afford the high price.

Stocks can be split two-for-one, ten-for-one, or in any ratio the company wants. (The less common "reverse split" is when the number of shares decreases, for example one-for-two.) To illustrate what happens when a stock splits, let's look at a simple example. Say you own 100 shares of stock in XYZ Corp. that are priced at $100 per share. XYZ decides that $100 per share is too high of a price for its stock, so it issues a two-for-one stock split. This means that for every share that you previously owned, you now own two shares, giving you 200 shares. When the stock splits, the price will be cut in proportion to the split ratio that was chosen by the corporation (in this case, to $50 a share). If you compare the amount of your investment before the split and the amount after the split you will notice that they are equal (100 shares x $100/share = $10,000; which is the same as 200 shares x $50/share = $10,000). So, in effect, nothing has changed from your perspective.

But although technically nothing changes for the investor during a stock split, in reality often times there are changes. Not only does the split tend to increase demand for shares by making the shares more accessible to small investors, it also usually garners favorable media attention. This tends to cause the price of a stock that has split to increase after the split. The split is interpreted by some as a sign that the company's management is confident that the stock's price will continue to rise. Of course, there is no guarantee that this will happen.

A buyback is a corporation's repurchase of stocks or bonds that it has previously issued. In the case of stocks, this reduces the number of shares outstanding, giving each remaining shareholder a larger percentage ownership of the company. This is usually considered a sign that the company's management is optimistic about the future and believes that the current share price is undervalued. Companies may decide to repurchase stock for many reasons. They may be attempting to improve the price to earnings ratio by reducing market capitalization, or they may want to offer the stock as an incentive to employees . It's important to note that when a company's shareholders vote to authorize a buyback, they aren't obliged to actually undertake the buyback. Some companies announce buyback plans as a sign of confidence, but it's meaningless unless they actually go through with the repurchase.

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