Stock Split

Introduction

Typically, listed companies engage in various corporate activities such as issuing bonus shares, distributing dividends, and more. When a corporation declares a stock split, the number of shares issued increases, but the market capital stays constant. Here, existing shares would be split, but their fundamental value would remain unchanged. The price of every share will increase with an increase in the number of existing shares split. This is a good sign for both current and prospective investors. 

What is a stock split?

The stock split meaning is when a listed company takes corporate action, it divides each current share into multiple new shares without changing the overall share value. The stake of each investor in the company also remains unchanged. However, the corporate action increases the number of shares of the company. 

What happens when a stock splits?

Stock splits often do not affect anything other than making company shares more accessible to investors. The share split meaning is when a company employs a certain ratio to determine the number of additional shares generated by dividing the existing shares. 

Investors will get an equal number of shares to their present holding in the firm. However, these shares would be adjusted to account for the stock split. The most typical split ratios are denoted as 2:1 or 3:1. This implies that for every share owned before the split, each owner will have two or three shares following the split.

Why companies use stock splits and How a Stock Split Works?

There are various reasons why a company would seek a share split. The first is psychological. 

As the value of a stock rises, some investors may believe it is too expensive to acquire. Dividing the stock lowers the share price and makes it more reasonable and attractive. While the stock's true worth remains the same, the decreased stock price may influence how the stock is viewed, tempting new investors. Splitting the stock also provides the current owners with an impression of having more shares than before. Thus, if the price rises, they will have more stock to trade.

Another, perhaps more rational, motive is to boost a stock's liquidity. The increased liquidity and ease in trading generated by the stock split encourages more buyers to engage in buying the stock. In such a scenario, companies sometimes repurchase their shares at a lower cost without causing any significant impact on more liquid security. This grows in proportion to the number of outstanding shares of the stock. 

As for how a stock split works — acquisitions, new product launches, and stock repurchases increase the value of the companies. At some point, the listed market price of the stock becomes too costly for investors, influencing market liquidity as fewer and fewer individuals can purchase a share.

Assume a publicly listed company XYZ, initiates a two-for-one stock split. Before the split, you had 100 shares at $80 each, for a maximum of $8,000 in value. As the divisor drops  the share cost of the split, an $80 stock turns to a $40 stock after the two-for-one split. Your overall capital value remains the same at $8,000 following the split. After the split, you still possess 200 shares at $40 each, so your entire investment would still be valued at $8,000.

Types of Stock Splits

A company can apply two kinds of stock splits to manage share prices:

The first is a regular stock split, whereas the latter is a reverse.

● Regular Stock Split

The company would do two things as part of the stock splits to make the company's shares appear more accessible to small investors:

Firstly, it would choose to expand the number of outstanding shares by issuing additional shares to present shareholders. 

Secondly, the corporation would allow the number of shares to increase, leading to a natural price drop. This indicates that the company's valuation and market capitalisation stay constant even when the number of shares increases and prices fall.

● Reverse Stock Split

In this stock split, the company lowers the number of shares remaining. So, if you held 10 shares of a company's stock and the board declared a 2-for-1 reverse stock split, you'd end up with five shares. 

The overall value of your shares stays unchanged. If the 10 shares were worth Rs. 4 each before the reverse split, the five would be worth Rs. 8 each after the split. In either instance, your total investment is still Rs. 40. However, you now hold fewer shares than you did previously.
 

Pros and Cons of Stock Splits

Pros

● Improved Liquidity

When the price of a stock increases by thousands of rupees per share, the trading activity tends to fall. Raising the number of shares outstanding at a lower per-share price increases liquidity, decreasing the spread between ask and bid prices and allowing investors to trade at lower prices.

● Make portfolio rebalancing simpler

When the price of each share falls, portfolio managers find it simpler to sell the shares to purchase new ones. Each trade represents a smaller portion of the portfolio.

● Make selling put options cheaper

Selling an option contract on a high-priced stock can be quite costly. A put option offers the purchaser the opportunity to sell 100 shares of stock (referred to as a "lot") at a specific price. The seller of the put must be willing to buy that stock lot.

● Often increase share price

The fact that stock splits tend to increase share prices could be the most convincing reason for a corporation to split its stock. Research examining large-cap company stock splits from 2012 to 2018 discovered that just announcing a stock split raised the share price by an average of 2.5%. Over a year, a stock that had split outperformed the market by an average of 4.8%.

Cons

● Could Increase Volatility

Due to the new share price, stock splits may trigger market volatility. Additional investors may opt to invest in the stock if it is more inexpensive, which might intensify the company's volatility.

● Not All Stock Splits Increase Share Price

Some stock splits happen if a company's stock is about to be delisted which are referred to as "reverse stock splits."

An Example of a Stock Split

Case Study: Tesla
Tesla declared a 5-for-1 stock split in August 2020. Tesla's shares traded at around $418 per share shortly after the split. They fetched over $625 a share four months following the split, a nearly 50% rise. Tesla's stock has reached $780!

Case Study: Apple
Apple divided its shares seven-for-one in June 2014 to make them more accessible to a wider range of investors. Before the split, the starting price of each share was roughly $649.88. At the market's opening following the split, the cost per share was $92.70.

Existing shareholders received six more shares for every share they held before the stock split. As a result, an investor who held 1,000 shares of Apple before the stock split suddenly owned 7,000 shares following the stock split. Apple's outstanding shares climbed from 861 million to around 6 billion.

However, as previously stated, the company's market capitalization remained substantially intact immediately following the separation. It was around $556 billion. However, the price rose to a high of $95.05 the day after the stock split, showing higher demand due to the reduced stock price.

Conclusion

The primary motive for purchasing a company's shares should not be a stock split. While firms divide their shares for psychological reasons, it does not affect the business realities. Remember that the split has no effect on the company's value as defined by its market capitalization. 

In the end, you have the same amount in the bank whether you have two Rs. 50 notes or a single Rs. 100 note. Furthermore, if you're investing in a company following a stock split, you should approach it with the same amount of study and interest as any other company. While a share split might be a good indication, it is always better to do your homework before investing in any firm.