Every stock market investor wants to invest in shares that can fetch good returns. Oftentimes shares of a sought-after company are not available for many investors to invest in. One of the most common reasons being the steep stock price. During such times, companies may decide to split their shares, resulting in a stock split.
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What is stock split?
A stock split is:
- when a company’s board of directors issue more shares
- issued to current shareholders
- when the current value of a shareholder’s stake is not diluted
It basically eases the total number of shares outstanding for a company and reduces the value of each share. So, although the total number of shares outstanding increases, the company’s valuation and the value of a shareholder’s stake in the company does not change.
Here’s an example to understand this:
Suppose you have one share of company ABC’s stock. If the company announces a 2-for-1 stock split, it will allot you an additional share. However, each share will now be valued at half the amount of the original value. Thus, post the split, the two shares you own will be worth the same as the one share you earlier had.
How is Stock Split calculated?
Calculating total shares after stock split
Shareholders who wish to estimate the total number of shares that they will own after a stock split can use the following formula:
Total number of shares post stock split = number of shares held * number of new shares issued for each existing share.
For example, you currently own 150 shares of a company that has announced a split ratio of 2:1. The total number of shares you will own after the stock split will be:
=150 X 2
=300
Calculating stock price after stock split
If you want to know the share price after a stock split, the following formula can be used:
New stock price = Old stock price/Stock split ratio
Thus, if a stock you own was last traded at a price of Rs.100 and the company has announced a stock split of 3:1, the new price of the stock will be:
= 100 /(3:1)
= 33.33
Why do companies announce split their stocks?
Here are some of the common reasons for this:
Higher liquidity
One of the main reasons why companies announce stock splits is to attain higher liquidity. In many cases, the company’s share price may be too high for investors to easily buy them. Any additional price rise may further discourage investors from participating in the company’s shareholding. By decreasing the value of a stock through a stock split, the shares can be made accessible to a larger investor population, thereby resulting in higher liquidity.
Wider stockholder base
Through this corporate action, a company can add on to the number of its outstanding shares and offer an opportunity to a wider investor base to buy its shares. This helps the company to increase its stockholder base.
Future growth perception
Companies that announce stock splits are generally perceived to be in the growth phase. Such announcements are considered by investors as an indication of the company’s intent to attain growth. This helps in creating a positive market image about the company.
Disadvantages of a Stock Split
Some of the disadvantages of stock split are:
- Reduced liquidity: Stock splits can increase the number of shares outstanding, potentially decreasing liquidity and making it harder to buy or sell shares.
- Lower price per share: The reduced share price after a stock split may attract more retail investors, leading to increased volatility and potential market manipulation.
- Market perception: Some investors view stock splits as a signal of overvaluation, which could affect the stock’s perceived value and future performance.
- Transaction costs: Investors may incur additional transaction costs, such as brokerage fees, when buying or selling a higher number of shares.
- Psychological impact: Stock splits can create short-term excitement, but they don’t fundamentally change a company’s value, and investors should focus on underlying fundamentals rather than just the split.
The table below highlights the key differences between these two:
| Stock Split | Bonus Shares | |
| Meaning | Existing outstanding shares are divided into multiple shares. | In this extra shares are given to shareholders free of cost. |
| Face value | Reduces in the same proportion as split. | Does not change |
| Why used by companies | To increase liquidity of shares. Decrease share price and allow more shareholders to participate. | Used as an alternative to dividend. For distributing accumulated reserves |
| Example | If a stock split of 1:2 is announced, for every 1 share held, the investor then has 2 shares in total. | If a 3:1 bonus issue is announced, shareholders get 3 shares free of cost for every one share held. Example – for 10 shares held, one gets 30 (3*10) shares in total. |
Conclusion
Stock splits can fetch greater returns for companies. It is seen as an indication of good performance of a stock and therefore helps in an increased price in the future. As per historical evidence, many stocks that have undergone a split are known to become profitable for investors in the long run.
FAQs
In a reverse stock split, a company reduces the total number of outstanding shares by a certain percentage while increasing the stock price by the same percentage. For instance, if one has 10 shares of Rs. 200 each and the company announced a reverse stock split of 1:2, the shares held will now be a total of 5 with a value of Rs. 400 for each.
The ratio of stock split depends on the company’s decision and its objective.
Reverse stock split helps a company to recover from losses and it can avoid an adverse outcome such as delisting. Many stocks tend to show an upward trend in prices after reverse stock split announcements.
Investors can benefit from stock splits depending on whether they are currently invested in the company. They can also research about the possibility of a stock split announcement and invest in shares to benefit from higher liquidity.
A stock split increases the number of outstanding shares of a company, whereas a stock dividend is a predetermined number of shares paid to existing shareholders instead of cash dividends. Both these increase the number of outstanding shares and therefore a proportionate reduction of share prices.
