Imagine you're an investor at XYZ company, one of the most influential. As the shares hit above Rs. 2000/-, it becomes critically out of reach for many investors at the individual level. Let's say for example - the stock of RIL company announced a 1:1 stock split, decreasing the price of each share by half. Instantly, the stock seems more accessible, and new investors drive in to buy it. This instance highlights the core concept of and potential impact that stock split has on investors. It is a standard corporate action that can influence the market dynamics and the investor's behavior.
Stock splits are very strategic and crucial for companies that adjust the pricing without changing the firm's underlying value. This article dives into the concept of stock splits, how they work, the pros & cons, and their potential impact on the market and the shareholders.
What is a Stock Split?
“A stock split is like cutting a pizza. Whether you cut it into four or eight slices (or you square-cut it into 24 slices), it’s still the same pizza.”
Generally, a stock split is a corporate action where a company divides its present shares into multiple ones. However, the number of shares increases in quantity, but the overall value and market capitalization remain the same. A stock split increases the number of shares outstanding while decreasing the price per share proportionally.
Think of it like this: when you cut a pizza into smaller pieces, the size of each piece is smaller, but the total amount and the value of the entire pie do not change. The same is true about the value of a company when a stock split takes place.
Look at the table below for example -
Types of Stock Split
Forward Stock Split
| Reverse Stock Split
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In a forward stock split, firms accelerate the number of their outstanding shares by issuing more to current shareholders. For instance, in a 2-for-1 split, each shareholder receives an add-on share for each share they own, effectively doubling the number of shares while halving the share price.
| In reverse stock split, an organization reduces the number of its outstanding shares, increasing the share price proportionally. For example, in a 1-for-2 reverse split, shareholders receive one new share for every two shares they own, effectively halving the number of shares while doubling the share price.
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Why Companies Use Stock Splits and How Do Stock Split Works?
There are various reasons why a company would seek a share split. The first is psychological.
As the stock's value increases, some investors might perceive it as too expensive to purchase. Splitting the stock reduces the share price, making it appear more affordable and attractive to potential investors. Although the stock's intrinsic value remains unchanged, the lower price can enhance its appeal and attract new investors. Additionally, a share split can give current shareholders the sense of owning more shares. Consequently, if the stock price rises, they will have more shares to trade.
Another practical reason for a stock split is to enhance its liquidity. The increased liquidity and ease of trading resulting from the stock split attract more buyers. Companies can sometimes repurchase their shares at a lower cost without significantly affecting the more liquid security. This growth is proportional to the number of outstanding shares.
As for how a stock split works — "When a firm wants to change their per-share prices while making the stocks more accessible to people."
Existing stakeholders receive add-on shares when a firm issues them, enhancing their total shares by a specific split ratio, i.e. typically 2:1 and 3:1. Firms choose to split their stocks to further down their share trading prices and offer a more affordable range to investors.
For instance, numerous investors would value investing in 100 shares of Rs.1000 stock rather than purchasing one share of Company X at Rs. 1000. So, the company's board of directors decides to bring in a stock split when their share prices climb. The BODs can select any split ratios such as - 2:1, 3:1, 5:1, 10:1, or 100:1. A 3-for-1 represents that you'll own three for every share you hold in firm X after the stock split.
Pros and Cons of Stock Split
Here's a table outlining the advantages and stock split disadvantages in a balanced way:
Advantages of Stock Split
| Disadvantages of Stock Split
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Increased Liquidity: A stock split increases the number of shares in the market, making it easy for investors to sell and buy the stock.
| No Change in Value: A stock split does not change the company's fundamental value; it simply divides the existing shares into more shares.
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Accessibility: Lower share prices can make the stock more accessible to more investors, including retail investors.
| Potential Overvaluation: Investors might perceive the stock as more valuable than it is due to the lower price per share.
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Broader Ownership Base: More investors can afford the stock, leading to a broader ownership base.
| Market Misinterpretation: Some investors might misinterpret the stock split as a sign of underlying issues within the company.
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Positive Signal: It can be seen as a positive signal that the company is confident in its future growth prospects.
| Costs: Administrative and legal expenses are associated with executing a stock split.
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Historical Performance: Companies that split their stock often have a solid performance history.
| Short-Term Volatility: Stock splits can increase short-term volatility as the market adjusts to the new share structure.
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Index Inclusion: A lower stock price might make it easier to include the stock in certain indexes.
| Complexity: The process can be complex and confusing for some investors, especially new ones.
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Real-World Instances of Stock Split in Indian Firms
The examples below demonstrate how Indian companies have used stock splits to improve liquidity , make shares more affordable for retail investors, and broaden their investor base. Here's the take:
1. Reliance Industries Limited (RIL)
One of India's largest conglomerates announced a stock split in 2009. The split was in the ratio of 1:2, meaning each share was divided into two shares. This move aimed to increase the stock's liquidity and make it more affordable for retail investors. So, this split increased trading volumes and made the stock more accessible to a wide range of investors, thus broadening the shareholder base.
2. Wipro Limited
Wipro, a major player in the IT sector, executed a stock split in 2010 with a ratio of 2:3. This meant that for every two shares held, shareholders received three shares post-split. This move aimed to enhance the liquidity of Wipro's shares and make them more affordable to small investors.
3. Tata Consultancy Services (TCS)
TCS announced a 1:1 stock split to make its shares more accessible to more retail investors. The move also aimed to improve liquidity in the market. After the split, TCS shares saw a positive response, with increased trading activity and investor interest.
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Stock splits can be a lucrative and important step for companies looking to draw in more investors. At Vega Equity , we make stock splits straightforward and profitable for you. Our seasoned expert team provides tailored advice and thorough market analysis to help you seize the best opportunities.
We also offer personalized investment strategies that align with your financial goals, ensuring you maximize returns and manage risks effectively. With our proven track record and full support from start to finish, you can confidently navigate stock splits and optimize your investment strategies. Book a demo for expert guidance, comprehensive analysis, and unwavering support on your investment journey.
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Final Thought
Henceforth, Stock splits make shares more accessible to a wide range of investors by making the shares more affordable. This deduction attracts more investors and increases trading volumes. Additionally, it also accelerates liquidity and makes it easy for investors to buy and sell shares.
But it is crucial to grasp that a stock split does not change the company's ingrained value. Instead, it simply redistributed the value across more shares. One major drawback: companies declaring stock splits are sometimes counted as financially unstable, reducing their stock price.
Without further ado, contact us at Vega Equity to attain comprehensive insights into strategic investment decisions, empowering investors to capitalize on market dynamics and optimize their investment strategies effectively.
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Written by Ali Nasir Kidwai 18 July 2024 | 4 min read
