With share splits, a company is simply cutting itself up into a number of pieces, without changing its fundamental value. It wants its stock to trade in a price-per-share range that seems reasonable to investors. This can affect stock market trading in more ways than one.

Stock market trading: How a share split works

Things haven’t changed: It’s still often the case that if a stock’s price rises much beyond $50 a share in Canada (or $100 a share in the U.S.), some investors may shun it, since it seems expensive. A company’s management may then opt for a share split, or stock split, of two-for-one. This turns one “old” share into two “new” shares. If you owned 100 shares of a $60 stock, you now own 200 shares of a $30 stock. You don’t need to take any action.

After conventional share splits, good news often follows. Companies mainly undertake share splits when they want to draw attention to themselves — because they expect earnings to rise faster than normal, say. At such times, they may also raise their dividends.

However, sometimes companies get overly optimistic. Their profits come in far below expectations, and they can’t keep paying the new, higher dividend. So a share split can be good or bad for your stock market trading, depending on the details.

Keep an eye open for spinoffs, not share splits

Some investors love share splits and rush to purchase them beforehand. While you may pick some winners by focusing on share splits, we feel that spinoffs are closer to a sure thing. A spinoff is when a division of a business is spun off into its own separate company. A number of studies have shown that after an initial adjustment period of a few months, spinoffs tend to outperform groups of comparable stocks for several years. For that matter, the parent companies also tend to outperform comparable firms for several years after a spinoff. That above-average performance makes sense for a couple of reasons.

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First, company managers naturally prefer to acquire or expand their assets, not get rid of them. Getting rid of assets reduces a company’s total potential profit, which reduces the funds it has available to pay its managers. The management of a parent company will only hand out a subsidiary to its own investors if it’s fairly confident that the subsidiary, and the parent, will be better off after the spin-off than before it.

Second, spinoffs involve a lot of work and legal fees. The parent will only spin off the unwanted subsidiary if it can’t sell the stock for what it feels it’s worth. That’s why companies only have an incentive to do spin-offs under two sets of favourable conditions: When they feel it isn’t a good time to sell (which often means it’s a good time to buy); or, when they feel the assets they plan to spin off will be worth substantially more in the future, possibly within a few years.

Oddly enough, many investors who embrace share splits react to spinoffs as a nuisance, because they leave you with a tiny holding in a stock you didn’t choose and know little about. Again, that’s often contrary to how investors feel about share splits. Both share splits and spinoffs can help you increase your wealth. But in general, share splits and consolidations (see below) are a minor investing detail. Don’t let them distract you from more important matters, such as a company’s fundamental value and how well it suits your investment objectives.

Consolidations: share splits in reverse

If the value of a stock collapses to pennies a share, investors may think it is headed for zero. To bring its share price back up to more-respectable levels, the company may move in the opposite direction of share splits and decide to declare a reverse split: five, 10 or more “old” shares will then turn into one “new” share. This “reverse split” is also called a “share consolidation.” It’s what usually happens to penny mining companies that have spent all their money without finding any valuable mineral deposits.

After a reverse split, stock prices often fall back down again. Some investors sell because the stock seems more expensive than it was, even though a given holding represents the same percentage ownership of the company. Others sell because they fear the company will raise money by selling new shares, and this will drive down its stock price.

Our investing advice: Stock splits and consolidations are a minor stock market trading detail. Don’t let them distract you from more important matters, such as a company’s fundamental value and how well it suits your investment objectives.

Note: This article was originally published in 2011 and is regularly updated.