What every investor should know about a stock split

In July this year, each shareholder of Tata Steel received nine additional shares. The Tatas weren’t particularly generous with this move. It was a step to reduce the price of their shares to make them more affordable for budding investors. This is a phenomenon called stock splitting.

What is a stock split?

When a company’s board of directors issues more shares to its existing shareholders without diluting the value of their holdings, it’s called a stock split.

Even though this increases the number of shares, it dilutes the individual value of each share. To do this, it divides each part into several parts. A stock split does not affect the market capitalization of the company in any way.

Let’s say the shares of a company are trading at Rs 100 and they have 20 million shares. The market capitalization of this company is Rs 200 crore (20 million * Rs 100). It does a 2 for 1 stock split. What happens?

If a shareholder owns one share, he receives another. She has two shares instead of one, but the value of their shares is halved. The value of each share is only Rs 50 now. But the market capitalization remains the same: Rs 50*40 million shares = Rs 200 crore.

In March of this year, Amazon announced that it would split its stock 20 for 1. This means that an investor will receive 20 shares for each share they currently own, or an additional 19 shares for each share they own. This is the company’s first spin-off since 1999 and the fourth since its IPO in 1997.

“This split would give our employees more flexibility in how they manage their capital in Amazon and make the stock price more accessible to people who want to invest in the business,” an Amazon spokesperson said.

Common Stock Split

Stock splits can be of different types. 2 for 1, 3 for 2 and 3 for 1 are the most common stock splits. To get the new stock price, you can divide the share ratio with the previous stock price.

Let’s say the value of the stock is Rs 100 and it is divided into four. Then, split to get the new share price i.e. Rs 25. If the share is split 2 for 1, the new share price is Rs 50.

How does a stock split work?

With several companies growing over time, stock prices also continue to rise. When the stock price keeps rising, it becomes difficult for new investors to invest money. This lack of affordability affects market liquidity.

Clothing manufacturer Page Industries Limited, exclusive licensee of Jockey International in India, is trading at Rs 50,130 at the time of writing. How many retail investors do you think will be interested in buying their share? Even though it is a high value and solid company, few investors will have the capital to invest in it.

After a stock split, even though there is no difference in the value of the stock as such, its price drops and the number of shares increases proportionally.

Historically, when strong companies do stock splits, it becomes a huge success because the stock starts trading at a reasonable price.

Why do companies split their stocks?

Companies use the stock split strategy to achieve specific goals. It is also a sign that the business is booming.

In June 2014, Apple split its stock 7-to-1 to make it more accessible to interested buyers. One goal might be to make the stock price more attractive to people who would then balk at its price.

For example, instead of buying the shares of MRF at Rs 98,599, you can buy them at Rs 9,859 after a 10 to 1 stock split. Note: MRF has never split its shares. This is one more reason why the stock price is at such a high rate, apart from reasons other than its good performance.

Warren Buffet’s Berkshire Hathaway has never split its Class A shares. It currently trades at $435,730 and is the most expensive stock in the world.

Even though a stock split increases the liquidity of the stock and makes it more accessible, few companies indulge in it as they prefer to keep the prices high as it adds to the attractiveness of the stock.

A stock split tells the market that the price of the stock has gone up and will continue to do so in the future. Hence, this will increase the demand for the stock, which will eventually increase the prices. This is called price discovery.

As more and more investors buy and sell a company’s stock, the true value of the stock can be determined.

Due to the new price at which a stock is trading after the split, more investors may decide to buy the stock due to its affordability. This can increase the volatility of the stock.

Advantages of a stock split for companies:

Facilitates market activity: After a stock split, there is an increase in trading as the stocks become more affordable to most investors. This will also lead to an increase in the stock price.

Improves liquidity: Stock splits increase the number of shares available to the public. This narrows the bid-ask spread and investors are excited to buy and sell stocks.

Simplified portfolio rebalancing: When a stock’s price drops, portfolio managers will find it easier to sell stocks to buy new ones.

Attracts investors: Once a stock split is complete, the decline in the stock price lowers the barrier to investing. It will attract new investors as it signals that the business is booming.

Biggest upside potential: When the price of a stock drops due to a stock split, it is more likely to grow faster than a more expensive stock.

What is a reverse stock split?

A stock split, on the other hand, is done by companies to help them meet the minimum requirements to be listed on a stock exchange. If the price continues to fall, it could reach that number below which the stock price will no longer list you.

By doing a stock split, the price per share increases and you can continue to trade on the stock exchange.

Although a stock split is not often encouraged and is considered a red flag by investors, it can be a temporary solution to get out of a difficult phase.

Apart from the above reason, it is also used to increase the value of company shares or to gain more respectability in the market.

For example, in a reverse stock split, 20 million shares at Rs 100 will become five million shares at Rs 400 each. In either case, the value of a shareholder’s investment remains the same.

Sometimes companies conduct a stock split to attract the attention of high-profile investors or to improve the company’s public image.

Advantages of a reverse stock split:

Minimum share price: Exchanges have minimum price requirements, below which they will remove the stock from the exchange. Whenever their stock price approaches the required minimum, companies announce a stock split to defuse the situation. Otherwise, investors will lose confidence in the stock; it doesn’t help the reputation either.

Boost the image: It is also done to retain or gain the favor of influential investors. Higher priced stocks get a lot of attention from potential investors and can be an excellent source of marketing for the company.

To match competitors: Companies conduct a stock split whose stock price is more in line with that of their competitors. Otherwise, potential investors might deem them less valuable. In tough times, stock splits provide a psychological boost to the company and to interested investors.

Disadvantages of a reverse stock split:

Price inflation: Since the reverse stock split increases the price of the stock without adding value, it can be seen as an effort to artificially inflate prices.

Reduces the number of shareholders: When you consolidate shares, the number of shareholders is reduced. They will receive a cash payment because they will not hold enough old shares to be eligible for the new share. They would also cease to have a stake in the business.

Reduces liquidity: When the number of shares available decreases, liquidity decreases since it becomes difficult for investors to buy or sell the shares.

Key terms investors need to know

When it comes to stock splits, investors should be aware of these terms:

Announcement date: The company announces the date of the split, including relevant details investors should know. It includes the share ratio and when it will happen.

Registration Date : This date is not relevant for investors, but it is important for accounting purposes. The record date refers to the date until which investors must hold the shares to be eligible for the new shares that will be created as a result of the stock split. If you buy or sell shares between the record date and the effective date, the new shares are transferred to the buyer.

Effective date: On that date, the new shares are reflected in investors’ brokerage accounts and you can trade based on the new allocation.

How Does a Stock Split Affect Investors?

If you’re a shareholder in a company that’s gone through a stock split, it’s natural for you to be concerned. Fortunately, this has no impact on you as an investor. After the stock split, your ownership percentage remains the same. Even though you will end up owning more shares, the value of each share will have decreased.

In fact, after a stock split, investors might actually see a surge in its trading as it has become more affordable.

Indian companies that have done a stock split

Globally, Amazon, Tesla, and Google have split inventory to make it more affordable. In fact, Apple has split its stock five times since the time they went public. Let’s look at a few Indian companies that have done a stock split this year.

Hindustan Foods: Their stock has gone from a face value of Rs 10 to Rs 2. It has seen a 37% increase in the last two days after the split.

High Energy Batteries Ltd: Over the past five years, the price of this stock has increased by 536%. The India-based battery manufacturing company divides its stock into five.

Savita Oil Technologies: The Mumbai-based company that deals in automotive and industrial lubricants has announced that it will split its shares into five on August 30, 2022.

A stock split or even a stock consolidation will not impact existing investors. When buying shares of a company, don’t because it recently announced a stock split.

Remember that stock splits do not change company fundamentals. The value of a company in the stock market is always measured by its market capitalization.

About Jason Norton

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