What is Stock Splits?
A stock split is an event in which a company divides its publicly available outstanding shares into multiple shares to increase the liquidity and affordability of its stock.
Stock splits are common occurrences in the share market, yet for many beginners, the concept can be a bit puzzling.
When the price of a company’s stock becomes too expensive (in terms of number) or the company wants to increase more liquidity in their outstanding shares to make it readily available for the public, it increases the number of shares by reducing the stock’s face value. This is called a stock split.
A 2-for-1 split is the most common stock split; this means that the people holding shares of the company will receive two shares for every one they previously held.
The overall value of the investment remains the same, but the number of shares increases.
Example- Imagine you have a stock that has a face value of ₹10. This is like saying each unit of stock is worth ₹10.
Now, let’s say something called a “2:1 stock split” happens. This means for every stock you had, you get two (one extra).
So, if you had one stock worth ₹10 before, after the split, you’d have two stocks, but each is now worth ₹5.
Even though the value per stock went down from ₹10 to ₹5, you have twice as many stocks.
So, if you had one stock worth ₹10 before, now you have two stocks, each worth ₹5. The total value of your stocks is still ₹10 (2 stocks x ₹5 each).
So, the total amount of money you have invested remains the same, even though the individual value of each stock is now less.
It’s like having two ₹5 bills instead of one ₹10 bill – the total money you have is still ₹10.
Why Do Companies Choose to Split Their Stock?
As the companies grow so do their share prices and it becomes expensive to buy even a single share of that company.
For that reason, companies often opt for stock splits so that their shares become more accessible to larger investors.
This way whoever wants to purchase the share can buy easily at an affordable price.
By reducing the price per share, a stock split can attract new investors who may have been deterred by a higher share price.
This increased accessibility can lead to a more diverse shareholder base.
Types of Stock Splits
Stock splits are typically categorized based on the ratio by which the existing shares are split. The two most common types of stock splits are:
Forward Stock Split:
Description: In a forward stock split, also known as a traditional or regular stock split, a company increases the number of its outstanding shares by issuing additional shares to existing shareholders.
Ratio: The split ratio is expressed as a multiple, such as 2-for-1, 3-for-1, or any other combination. For example, in a 2-for-1 forward split, shareholders receive two shares(one additional) for every one they currently hold.
Impact: While the number of shares increases, the overall market capitalization remains the same, and the stock’s price per share decreases proportionally.
Reverse Stock Split:
Description: In a reverse stock split, a company reduces the number of its outstanding shares by consolidating existing shares. This is often done to increase the stock’s price per share.
Ratio: The reverse split ratio is expressed as a fraction, such as 1-for-2, 1-for-3, or any other combination.
For instance, in a 1-for-2 reverse split, shareholders exchange two existing shares for one new share.
Impact: While the number of shares decreases, the overall market capitalization remains the same, and the stock’s price per share increases proportionally.
It’s important to note that both forward and reverse stock splits aim to adjust the stock’s price to a level that is perceived as more attractive or appropriate for the company and its investors.
The decision to implement a stock split is influenced by factors such as the company’s growth, market conditions, and the desire to appeal to a broader range of investors.
Additionally, some companies may choose to use a combination of forward and reverse stock splits, known as a combination split, to achieve specific financial or strategic objectives.
In a combination split, a company may, for example, perform a reverse split followed by a forward split, or vice versa.
Impact of Stock Splits on Investors:
For existing shareholders, a stock split doesn’t change the overall value of their investment.
If you owned 10 shares valued at Rs. 100 each before a 2-for-1 split, you would then own 20 shares valued at Rs. 50 each after the split. The total value remains Rs. 1,000.
Perception and Trading Activity:
Stock splits can create a perception of positive momentum around a company, as a lower share price may attract more attention from both retail and institutional investors.
This increased interest can lead to higher trading activity, potentially impacting the stock’s short-term performance.
Long-Term Implications:
While stock splits can result in short-term price movements, their long-term impact is often limited.
The fundamental value of the company doesn’t change; only the number of shares and their individual prices adjust.
Investors should focus on the underlying strength of the company rather than reacting solely to the split.
Advantages of Stock Splits:
Increased Liquidity:
Stock splits often lead to an increase in the number of outstanding shares, making the stock more liquid. This can attract a broader range of investors and enhance trading activity.
Accessibility:
Lowering the share price through a stock split can make the stock more accessible to individual investors, potentially increasing shareholder diversity.
Positive Perception:
A lower share price may be perceived as more attractive, fostering a sense of affordability and opportunity. So the stock split creates a positive perception for the investors.
Marketability:
Companies may use stock splits as a marketing tool to generate interest and attract attention from both retail and institutional investors.
Options for Dividends:
A lower share price after a stock split may make it more feasible for a company to issue dividends, as the cash outlay per share becomes more manageable.
Disadvantages of Stock Splits:
No Inherent Value Change:
A stock split does not inherently change the fundamental value of a company. It only alters the number of shares and their individual prices.
Perceived Volatility:
Some investors may interpret stock splits as a sign of volatility, potentially leading to short-term price fluctuations that are unrelated to the company’s performance.
Transaction Costs:
While stock splits do not affect the total value of an investment, they can result in increased transaction costs for investors who may need to adjust their portfolios after the split.
Lack of Impact on Market Capitalization:
Although the number of shares increases, the overall market capitalization of the company remains the same after a stock split. This may disappoint investors expecting a fundamental change.
Focus on Short-Term Performance:
Investors might be tempted to focus on short-term stock movements post-split, potentially neglecting the long-term fundamentals of the company.
Psychological Impact:
Stock splits can affect psychologically to investors. Some may misinterpret a lower share price as a signal of a declining company, even though the intrinsic value remains unchanged.
Conclusion:
In essence, stock splits are strategic moves by companies to make their shares more affordable and attractive to a wider investor audience.
For beginners in the world of investing, understanding the basics of stock splits is crucial for making informed decisions.
Remember, while stock splits may create temporary fluctuations, the underlying value of your investment remains unchanged.
As always, it’s wise to consult with financial professionals and do thorough research before making any investment decisions.
FAQs: Understanding Stock Splits
Q1: What is a stock split with an example?
A: A stock split is a corporate action where a company increases the number of its outstanding shares while simultaneously lowering the price per share.
For example, in a 2-for-1 stock split, if you owned 10 shares valued at Rs. 100 each, after the split, you would have 20 shares, each valued at Rs. 50. The final value of your investment remains unchanged.
Q2: Is a split good for a stock?
A: The impact of a stock split on a company’s stock can vary. In the short term, a stock split can create positive momentum, attracting more investors due to the lower share price.
However, the long-term impact is generally limited, as the fundamental value of the company remains unchanged.
Whether a split is “good” depends on the company’s goals and the investor’s perspective.
A: A 10-to-1 share split means that for every share an investor owns, they will receive 10 new shares.
If you initially had 10 shares valued at Rs. 100 each, after the split, you would have 100 shares, each valued at Rs. 10. Again, the total value of your investment remains constant.
A: Both bonus shares and stock splits aim to increase the number of outstanding shares. However, they differ in their mechanisms.
A bonus share issue involves the issuance of additional shares to existing shareholders without changing the share price, while a stock split involves a proportional increase in shares with a proportional decrease in share price.
The choice between the two depends on the company’s goals and the desired impact on shareholder perception.
There’s no one-size-fits-all answer, and the decision is often based on specific circumstances and strategic considerations.