What's a spread and what's a split?

This section delves into two questions often asked by investors: what is a spread and what is a stock split? 

What’s a spread?

Let’s say you want to by those 500 shares of Microsoft at $70 per share.  Chances are your order will be matched with someone who is selling 500 shares at some price lower than $70: maybe $69½ or $69¾ per share.  The broker, or other middleman, arranges trades to buy shares at, say, $69½ per share, and sell them to you at, perhaps, $70 per share.  This difference between the buy and sell price (the bid and the ask price) is the “spread.”  So the transaction is profitable for three reasons: the seller pays a commission, the buyer pays a commission and the middlemen get to keep the spread.  Actually, the spread I used, 50¢, is high nowadays.  Spreads are often lower than this—depending on the company in question.

If the company is very liquid,  then the spread is narrower.  Liquid means a lot of trades per day.  If the company doesn’t have many trades per day—that is, it is illiquid— then the spread between the bid and the ask price is likely to be higher.  Note that many theoretic models used to evaluation stocks, options (more on those later) and the value of a portfolio (a basket of different stocks) assume that there is, essentially, no spread between the offer and ask prices.

What’s a stock split?

Stock price appreciation correlates with earnings.  If a company performs very well—increases earnings steadily from year to year—then the stock price is also likely to appreciate.

When companies go public, the IPO price is often placed in the teens.  If the company is a great growth company—growing at 30 to 40% each year—it won’t take long for the price of a share to exceed $100.  High priced shares are not necessarily a concern for institutional investors—pension funds, etc.—where trades of $500,000 are not uncommon.  However, a high priced share can cause problems for the small investor.  Here’s why.

People still buy shares in round lots of one hundred.  If the price of a single share is $100, the trade would cost $10,000 (100 shares times $100 per share) plus a commission (often $5 to $30).  The average portfolio (collection of stocks) is under $40,000, so $10,000 worth of a single stock reduces the overall diversity of the portfolio.  Companies have stock splits to alleviate such problems.

By the way, a word of caution is necessary here.  Not all IPOs are great growth companies; in fact, about nine out of ten lose value in the first year of trading.

If the shares are trading at $100, the company might declare a two-for-one stock split.  In other words, once the split takes effect, each share becomes two shares; the stock prices drops in half.  If you owned 100 shares of a company worth $100 each, after the split you would own 200 shares each worth $50.  The total investment is identical in both cases.

Stock splits can make the shares more liquid, since the number of shares has increased and the price has dropped.  Berkshire Hathaway, the compound founded by Warren Buffett is famous because it has never had a stock split.  Berkshire Hathaway, on August 23, 2008, closed at the astronomical price of $116,100 a share.  The company has traded as high as $151,650.00.