In July this year, every stock owner of Tata Steel received nine extra shares. The Tatas weren’t being particularly generous with this move. It was a step to reduce their share prices to make it more affordable for aspiring investors. It is a phenomenon called stock split.
What is a stock split?
When a company’s board of directors issues more shares of stock to its existing shareholders without diluting the value of their stakes, it is called a stock split.
Even though it increases the number of shares, it dilutes the individual value of each share. It does this by dividing each share into multiple ones. A stock split doesn’t affect the company’s market capitalisation at all.
Let’s say a company’s stock is traded at Rs 100 and it has 20 million shares. This company’s market capitalisation is Rs 200 crore (20 million*Rs 100). It does a 2-for-1 stock split. What happens?
If a shareholder has one share, she receives another share. She has two shares instead of one, but the value of their stock is cut by half. Each share’s value is only Rs 50 now. But the market cap stays the same: Rs 50*40 million shares = Rs 200 crore.
In March this year, Amazon announced that it would split its stock 20-for-1. It means, an investor will receive 20 shares for each share they own presently, or 19 extra shares for every share they own. It is the company’s first split since 1999 and fourth since its IPO in 1997.
“This split would give our employees more flexibility in how they manage their equity in Amazon and make the share price more accessible for people looking to invest in the company,” said an Amazon spokesperson.
Common stock splits
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 split ratio with the previous stock price.
Let’s say that the stock value is Rs 100 and it is being split into four. Then divide each other to get the new stock price, that is, Rs 25. If the stock does a 2-for-1 split, the new stock price is Rs 50.
How does a stock split work?
With several companies growing with time, stock prices also keep increasing. When the price of the stocks keep increasing, it becomes difficult for new investors to pour money in. This lack of affordability forces affects the market’s liquidity.
Apparel manufacturer Page Industries Limited, the exclusive licencee of Jockey International in India, trades at Rs 50,130 at the time of writing this. How many retail investors do you think will be interested in buying their share? Even though it is of high value and a solid company, not many investors will have the necessary capital to invest in it.
After a stock split, even though there is no difference in the stock’s value as such, its prices come down and the number of shares go up proportionately.
Historically, when solid companies do stock splits, it becomes a huge success as the stock starts trading at a reasonable price.
Why do companies split their stocks?
Companies use the stock split strategy to meet specific goals. It is also a sign that the company is thriving.
In June 2014, Apple split its shares 7-for-1to make it more accessible to interested buyers. One objective might be to make the price of the stock more attractive for people who will balk at its price then.
For example, instead of buying MRF’s stock at Rs 98,599, you could buy it at Rs 9,859 after a 10-for-1 stock split. Note: MRF has never split its stock. It is one more reason why the stock price is at such at a high rate, apart from reasons other than its good performance.
Warren Buffet’s Berkshire Hathaway has never split their class A shares at all. It is currently trading at $435,730, and is the world’s most expensive stock.
Even though a stock split increases the stock’s liquidity and makes it more accessible, not many companies indulge in it as they prefer to keep the prices high since it adds to the attractiveness of the stock.
A stock split indicates to the market that the share’s price has been increasing and will continue to do so in the future. Therefore, it will increase the demand for the stock, which will eventually increase prices. This is known as price discovery.
When more and more investors buy and sell the shares of a company, the real value of the share can be arrived at.
Because of the new price at which a stock is traded after the split, more investors might decide to purchase the stock because of the affordability. It can increase the volatility of the stock.
Benefits of a stock split for companies:
Facilitates market activity: After a stock split, there is an increase in trading since the shares become more affordable to most investors. It will also lead to an increase in the share’s price.
Improves liquidity: Stock splits increase the number of shares that are available to the public. It reduces the bid-ask spread and investors are enthused to buy and sell shares.
Simpler portfolio rebalancing: When the price of a stock reduces, portfolio managers will find it easier to sell shares to buy new ones.
Attracts investors: Once a stock split is over, the reduction in the stock’s price reduces the barrier for investing. It will attract new investors as it signals that the company is a thriving one.
Greater upside potential: When a stock’s price reduces because of a stock split, there are greater chances of it growing faster than a more expensive stock.
What is a reverse stock split?
A reverse 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 keeps dropping, it might hit that number below which stock prices won’t list you anymore.
By doing a reverse stock split, per-share price increases and you can keep trading on the exchange.
Even though a reverse stock split isn’t encouraged often and is seen as a red flag by investors, it can be a temporary solution to emerge from a rough phase.
Apart from the above reason, it is also used to increase the value of the company’s shares or to get 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 stockholder’s investment remains the same.
Sometimes, companies do a reverse stock split to draw the attention of high-profile investors or to improve the company’s public image.
Benefits of a reverse stock split:
Minimum stock price: Stock exchanges have minimum price requirements, below which they will delist the stock in the exchange. Whenever their share prices approach the minimum requirement, companies announce reverse stock split to diffuse the situation. Otherwise, investors will lose faith in the stock; it also doesn’t help the reputation.
Boosts image: It is also done to maintain or gain favour from influential investors. Higher priced stocks attract a lot of attention from potential investors and can be an excellent source of marketing for the company.
To match competitors: Companies do a reverse stock split fir share prices that are more in line with that of their competitors. Otherwise, potential investors might deem them less valuable. In hard times, reverse stock splits give a psychological fillip to the company, and to interested investors.
Disadvantages of a reverse stock split:
Price inflation: Since reverse stock split increases the price of the stock without adding any value, it can be seen as an effort to inflate the prices artificially.
Reduces shareholder number: When you consolidate shares, the number of shareholders get reduced. They will be given a cash payout since they won’t hold enough of the old shares to be eligible for the new share. They would also stop having any ownership interest in the company.
Lowers liquidity: When the number of shares available decreases, liquidity reduces since it becomes difficult for investors to buy or sell the shares.
Key terms investors should know
When it comes to stock splits, investors should know these terms:
Announcement date: The company announces the date for the split, including relevant details the investors should know about. It includes the split ratio and when it will happen.
Record date: This date isn’t relevant to investors, but it is important when it comes to accounting. The record date refers to the date until when investors have to own the stock to be eligible for the new shares that will be created because of the stock split. If you buy or sell shares between the record date and the effective date, new shares get transferred to the buyer.
Effective date: On this date, new shares get reflected in the investors’ brokerage accounts and you can trade based on the new split.
How does a stock split affect investors?
If you are a shareholder in a company that did a stock split, it is natural that you would be worried. Thankfully, it has no impact on you as an investor. After the stock split, your ownership percentage stays the same. Even though you will end up owning more shares, the value of each share would have reduced.
In fact, after a stock split, investors might actually see a spurt in its trading since they have become more affordable.
Indian companies that did a stock split
Globally, Amazon, Tesla, and Google have split their stocks to make it more affordable. In fact, Apple has split its stock time five times since the time they went public. Let’s look at a few Indian companies that did a stock split this year.
Hindustan Foods: Their stock split from a face value of Rs 10 to Rs 2. It witnessed a 37% increase in the last two days post the split.
High Energy Batteries Ltd: In its last five years, this stock’s price has increased by 536%. The India-based battery manufacturing company is splitting its stock into five.
Savita Oil Technologies: The Mumbai-headquartered company that deals with automotive and industrial lubricants has announced that it is splitting its stock into five on August 30, 2022.
A stock split or even a reverse stock split will not have an impact on existing investors. When you buy a company’s stock, do not do so because it has recently announced a stock split.
Do remember that stock splits don’t change the fundamentals of the company. A company’s worth in the share market is always measured in terms of its market capitalisation.
