More to Stock Splits Than Previously Thought
June 13, 2000
Between 1943 and 1994, the S&P Composite Index rose by over 1,500 percent; yet the average New York Stock Exchange (NYSE) share price remained virtually unchanged. This is partially due to stock splits, where a public corporation issues two or more shares at a fraction of their value for each original one. Previous studies have concluded that stock splits signal liquidity and bright future prospects for the specific stock.
A recent study however, concludes that stock splits increase a stock's profitability by increasing the tick's percentage of the entire stock. The tick size is the minimum trading price variation, generally $0.125 on U.S. exchanges. When a stock splits, the tick size comprises a larger percentage of the entire stock than before. The study finds that after a stock split:
- The number of small buy trades increase significantly, and buy orders dominate small trade on every one of the 66 days following the splits.
- The profitability of brokers increases -- more shares are traded per dollar and consequently, commissions increase, motivating brokers to trade them aggressively.
- And by decreasing the spread of a stock's value, there are fewer trading errors and negotiation costs.
However, the study also notes that broker and market maker demand for stock splits are not the sole explanation of stock splits.
Source: "What Drives Stock Splits?" Economic Intuition, Winter 2000. Based on: Paul Schultz, "Stock Splits, Tick Size and Sponsorship," Journal of Finance, forthcoming.
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