Earlier in this module under the purposes of corporate actions, we read about stock splits impacting the price of the shares. Let us discuss the concept of stock split in this section.
What is Stock Split?
A stock split is a corporate action which splits the existing shares of a particular face value into smaller denominations so that the number of shares increases, however, the market capitalization or the value of shares held by the investors post-split remains the same as that before the split.
For e.g. If a company has issued 1,00,00 shares with a face value of ₹10, the current market price being ₹100, a 2-for-1 stock split would reduce the face value of the shares to ₹5 and increase the number of the company's outstanding shares to 2,00,00 (1,00,00* (10/5)). Consequently, the share price would also fall to ₹ 50 so that the market capitalization or the value shares held by an investor remains unchanged. It is the same thing as exchanging a ₹100 note for two ₹ 50 notes; wherein the value remains the same.
Let us see the impact of this on the shareholder: - Let's say company ABC is trading at ₹4 and has 1 million shares issued, which gives it a market capitalization of ₹ 4 million (₹ 4 x 1 million shares). An investor holds 400 shares of the company valued at ₹1,600. The company then decided to implement a 4-for-1 stock split (i.e., a shareholder holding 1 share, will now hold 4 shares). For each share shareholders currently own, they receive three additional shares. The investor will therefore hold 1600 shares. So, the investor gains 3 additional shares for each share held. However, this does not impact the value of the shares held by the investor since post-split, the price of the stock is also split by 25% (1/ 4th), from ₹ 4 to ₹1, therefore the investor continues to hold ₹1,600 worth of shares. One must note that the market capitalization stays the same - it has increased the number of stocks outstanding to 4 million while simultaneously reducing the stock price by 25% to ₹ 1. The true value of the company hasn't changed. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. In the case of our example, divide ₹4 by 4 and we get the new trading price of ₹ 1. If a stock were to split 5-for-2, we'd do the same thing: 4/ (5/2) = 4/2.5 = ₹ 1.6.
Colloquially speaking, a stock split can be thought of as cutting a cake into smaller digestible slices. The premise is simple - nothing really changes whether you eat two small pastries instead of a large one.
Reasons for Stock Split & Implications of a Stock Split
It is natural for one to question the rationality behind a stock split. Fundamentally, there is no effect whatsoever. However, companies cite some other reasons:
- One among them is that participation in the company's shares gets lower because investors shy away at an abysmally high price. Generally small and retail investors have a mentality that shares in smaller denominations are cheaper and thus they keep away from an overpriced stock. This leads to reduced investor interest.
- The second reason would be to improve liquidity in a company's stock by increasing the number of outstanding equity shares.
Example: If a stock is quoting at a market price of ₹1000 and has a face value of Rs 10, a stock split of 10:1 will bring the stock price down to ₹100 and make it more attractive & affordable for investors.