How share splits (and consolidations) affect your stock market trading

When a company splits its shares, it is simply cutting itself up into a different number of pieces, without changing its fundamental value. It simply wants its stock to trade in a price-per-share range that seems reasonable to investors.

Stock market trading: How a share split works

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. The company’s management may then declare a stock split of, say, 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 a conventional stock split, good news often follows. Companies mainly split their shares 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 stock split can be good or bad for your stock market trading, depending on the details.

Potash Corp. followed the typical share split pattern

Potash Corp. of Saskatchewan (symbol POT on Toronto), one of the companies we analyze in our Successful Investor newsletter, recently split its shares on a 3-for-1 basis after announcing sharply higher revenue and earnings for 2010.

Prior to the split, Potash was trading at around $184 a share. It now trades at $54.49 a share.

The company also raised its quarterly dividend by 110.0%, to $0.07 U.S. (post-split) from $0.033 U.S. The new annual rate of $0.28 U.S. (post-split) yields 0.5%.

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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 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.

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