A stock split occurs when a company increases the number of its shares by creating additional shares. Thus, it lowers the price of each share, but there appears to be no change in the total value of all outstanding shares. Companies usually do this to attract investors’ attention with an additional focus on stock liquidity.
In a stock split of 2-for-1, one stock becomes two, and its price becomes half. The value of a company stays the same after a stock split, but its share price becomes more affordable. Unsure how this works? Gaining a thorough understanding of stock splits will help you decide on finance-related matters or investments with precise knowledge.
Continue reading this blog to learn what a stock split is, its types, advantages, drawbacks and more.
Stock Split Meaning
Stock split refers to a corporate action where a company decides to break and divide its already existing shares into multiple shares to make trading easier. Now, there are more shares. However, the total market value of this company remains unchanged because the price of each share is reduced by the number of times it is split.
In most cases, a company follows a specific ratio for splitting its stock and determining how many shares it will get divided into. Common stocks are usually split following a ratio like 2 for 1 or 3 for 1, which means that shareholders receive two or three shares against one share owned, respectively.
One important thing to keep in mind is that splitting of stocks lowers the share prices, but it does not have much impact on current shareholders. This is because the company reduces the face value of each share by a fixed ratio. By dividing the previously issued shares, the total number of shares increases while the price of each share decreases. This leads to no net change for shareholders.
How do Stock Splits Operate?
A stock split is a corporate action that causes the number of shares to increase while lowering its prices. This is designed specifically to make necessary adjustments in the share structure without causing an impact on a company’s overall market capitalisation.
For this process to begin, the board of directors of a company must approve the stock split decision. They help in determining the split ratio, such as 3 for 1 or 5 for 1, which denotes the issuance of new shares for each existing share. For instance, in a 2-for-1 split, each shareholder expects to obtain two shares for each share owned.
After the execution of a stock split, the prices of shares are adjusted accordingly to the pre-decided ratio. To understand how stock split works, consider an example. If a stock was trading at ₹300 before a 3-for-1 split, it would now adjust to ₹100 each share after a split.
After the date of distribution, the new shares are automatically credited by brokers to the accounts of shareholders, considering their holdings before the split. This kind of adjustment is useful for investors who experience an increase in the number of shares held in their Demat accounts without having to take any action.
What are the Benefits of Stock Splits?
Here are the distinguishing features and benefits of stock splits:
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Boosts Liquidity
Dividing the stock increases the number of shares that are accessible on the market, which may increase the stock’s trading volume. Increased trading volume can improve liquidity, making it simpler for investors to buy and sell the stock.
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Encourages New Investors
A wider range of investors who might have deemed the pre-split price too high may now be able to purchase the stock due to the lower price per share after the split. This may increase demand for the stock and attract new investors, which could raise its value.
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Increases Market Capitalisation
A stock split does not directly increase a company’s market capitalisation since the total market value remains the same. However, the increased number of investors buying shares at a more attractive price may lead to a rise in market capitalization. Institutional investors who may have previously shunned the company because of its lesser market capitalisation may find this appealing.
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Creates a Sense of Affordability
A company can change its investors’ perception and make its shares appear more affordable by dividing its stock. A stock valued at ₹1,000, for example, would seem unaffordable to some, but with a 2-for-1 split, the new price of ₹500 per share might seem more reasonable. This also lowers the minimum investment requirement, giving more flexibility to investors.
What are the Drawbacks of Stock Splits?
Here are a few disadvantages of stock splits that all investors and businesses should keep in mind:
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No Effect on Company Worth
The basic value of the company remains unchanged after a stock split. The company’s earnings, overall market value, and fundamental financial health remain unchanged before and after the split.
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Indication of Financial Ups and Downs
A company’s decision to split its stock may occasionally be interpreted as an indication of financial difficulties or a lack of confidence in its prospects for the future. Investor sentiment and the stock’s price may suffer as a result of such a viewpoint.
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Increased Fluctuation
A stock split could result in higher price fluctuations, potentially causing larger discrepancies between purchase and selling prices, along with more noticeable short-term volatility.
Example of Stock Split
Let us understand the concept of stock split with an example:
Suppose the original price of the share for Company X is ₹1,400, and the split ratio is 2:1.
Before the split:
- Suppose an investor owns 10 shares of Company X, each valued at ₹1,400
- Total investment thus will be 10 shares* ₹1,400/share = ₹14,000
After the split:
- Suppose an investor receives 2 additional shares for each share already existing, which thereby results in a total of 10*2 shares = 20 shares
- The share price is adjusted accordingly to reflect the split ratio. Thus, it becomes ₹(1,400/2) = ₹700 for each share
- The total investment of the investor stays the same: 20 shares * ₹700 = ₹14,000
What are the Different Types of Stock Splits?
The different types of stock split take into consideration the traditional split, where the shares increase and the price for each share decreases. Conversely, for a reverse split, the number of shares reduces as their price increases. Let’s consider the different types of stock split in detail below:
- Reverse Split: Here, shares are consolidated, and the individual value of shares increases. A 1 for 2 reverse split merges together two shares into a combined one and thereby doubles the price of each share. This gradually brings about improvement in market perception or exchange listing criteria.
- Traditional Split: Here, the number of shares is multiplied, and each individual share is made more affordable. For example, a 2-for-1 split transforms one share into two, thereby lowering the price of each share by half, thus increasing accessibility.
Why do Companies Undergo Stock Splits?
Even if a company’s market capitalisation is unaffected, it may decide to split its stock to double or triple its total number of outstanding shares for the following two main reasons:
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Perceived Affordability
A high share price may demotivate some investors from purchasing a company’s stock because it appears excessively costly. Through a stock split, the company essentially reduces the price per share without altering its total worth. Because the stock looks less risky when it is more financially accessible, this perceived affordability may draw in additional investors.
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Accessibility
A stock split that lowers the share price might improve the stock’s liquidity. A reduced price might make it simpler for additional investors, particularly those with little or limited funds, to invest in the business. More trading activity in the stock and a wider shareholder base may result from this improved accessibility.
Effect of Stock Split on Investors
Once the splitting of stocks is announced and introduced in the market following a specific ratio (such as 1:2 or 1:3), your investment value remains unaffected. If the company issues cash dividends to its shareholders already existing in the market, it will issue a record date. When a company announces dividends, it also determines the eligibility of investors considering the shares they hold before the stock split. After stock splitting, the total dividend remains unaffected but the per share dividend is adjusted because of the increase in shares.
Final Words
By now, you must have a clear understanding of stock splits. Stock splits make a stock more accessible to investors by reducing its price. They do not make any changes in the total value of the company but create an impact on the overall stock demand. A forward split raises the number of shares, whereas a reverse split reduces the shares to boost the price.
Most companies in the present-day world use stock splits to attract new investors. Gaining knowledge of these stock splits helps investors reach a well-informed decision. Be it about purchasing or holding stocks, knowing about stock splits can assist investors with the management of investments to maximise returns.
