What is a Stock Split? Meaning, Types, Benefits and Impact on Investors
A stock split is one of the most common corporate acts declared openly by publicly listed companies. A stock split means that the number of shares in the company increases and the price of each share falls accordingly. While this affects the share count and market price, it will not affect the total value of an investor’s holdings.
Stock splits are frequently talked about in the stock market as they can make shares more accessible and boost trading volume. Understanding how stock splits work can help investors make knowledgeable decisions and avoid common mistakes.
What is a Stock Split?
A stock split involves a corporate transaction in which a company increases the number of its outstanding shares by dividing existing shares into multiple shares according to a predetermined ratio. The effect is that extra shares are added to the shares owned by the shareholders and the share price is adjusted in a corresponding manner.
The main reason for splitting a stock is to lower the trading price of a company’s shares without altering the stock’s valuation in the market. A stock split does not instantly increase the wealth of investors because the total market cap of the company stays the same.
Companies usually publicise stock splits when their share prices have increased substantially over time and management wants to keep the stock accessible to a larger number of investors.
How Does a Stock Split Work?
When a company announces a stock split, it specifies a split ratio. This ratio determines how many shares a shareholder will get after the split for each share they held before the split. After the stock split, the number of outstanding shares increases according to the announced split ratio. Meanwhile, the market price of each share decreases proportionately.
The process does not impact the company’s earnings, cash flow, profitability or intrinsic value. Instead, it only changes the number of shares available for trading and their market price.
A stock split is authorised by the company’s board of directors and made known to shareholders by press releases and SEC filings. In some jurisdictions, shareholder approval may also be required.
Why Do Companies Announce Stock Splits?
There are a number of reasons why companies may choose to split their shares.
- Improve Share Affordability: Retail investors may be deterred from buying the stock if a company’s share price is too high. Companies make their shares accessible by reducing the trading price, in this way, making them more affordable.
- Increase Liquidity: A stock split can lead to more shares being traded on the market. This could help to enhance trading activity and facilitate investors to purchase and sell shares.
- Attract More Investors: Having a lower share price can attract more investors, particularly retail investors.
- Enhance Market Visibility
Stock split notifications tend to create interest among investors, analysts and financial media, raising the company’s profile in the market.
Effectively maintain an attractive trading range
A lot of firms prefer that their shares stay in a price range that is comfortable for their investors. The purpose of this is to be achieved by stock splits.
What are the Types of Stock Splits?
There are two types of stock splits forward stock split and reverse stock split given below:
A) Forward Stock Split
A forward split involves dividing the shares into more than the company originally had, while decreasing the share price accordingly. This is the most common kind of split and is generally conducted when the share price of the business has climbed significantly over the years. The primary goal of a forward split is to make stocks more affordable and gain market interest.
B) Reverse Stock Split
A reverse stock split is when there is a percentage reduction in the number of a company’s outstanding shares, and the share price rises. Reverse stock splits can be used by companies to comply with stock exchange listing standards, to boost market confidence in the stock, or to raise the stock price.
Reverse stock splits are not as common as forward stock splits and are typically done for strategic reasons.
Example of a Stock Split
Assume that an investor has 100 shares in a company whose share price is ₹1,000.
When the company announces a 2:1 stock split, the investor will receive 200 shares after the split. Meanwhile, the price of the share will be adjusted to ₹500 per share.
The total value of the investment won’t change, because the share price reduces by half, and the number of shares doubles.
This exemplifies that when a stock splits, the quantity of shares and the share price will change, but the value of an investor’s shares will not change immediately.
Advantages and Disadvantages of Stock Splits
Advantages
- Better Accessibility: When the share price declines, it becomes more affordable for retail investors to purchase shares.
- Improved Liquidity: More shares in circulation can help boost trading volume and liquidity.
- Greater Investor Participation: Lower share prices could lend to a more extensive investor base.
- Positive Market Sentiment: Stock splits can be interpreted as an indication of the company’s long-term growth.
Disadvantages
- The fundamental value of the stock is not expected to change
- A stock split won’t boost the company’s profits, revenues, or business performance.
- Possibility of Misinterpretation: A stock split is not a sign that a stock is a good investment; that’s a common mistake that some investors make.
- Increased Volatility: Increased trading can result in increased short-term volatility
- No Guarantee of Future Returns: A stock split does not ensure that the share price will continue to rise in the future.
What is the effect of a Stock Split on Shareholder Wealth?
Shareholder wealth is not increased by a stock split. Investors are given more shares but the share price goes down in turn. This means that the total value of their assets does not change right after the split.
In the same way, the company’s market cap does not increase as the number of shares increases but the share price decreases. The future value of an investment is based on the performance of the business, not the stock split.
Stock Split vs Bonus Shares
Both Stock Splits and bonus shares involve an increase in the number of shares that the investors hold, so they can be mistaken for each other. But there are key distinctions.
- A stock split is when the shares are split into more shares and the face value of each share is reduced accordingly.
- A bonus issue involves a distribution from a company’s reserves of extra shares to its shareholders. Face value of shares is not affected.
- Both actions lead to the creation of more shares offered but have different objectives, accounting methods and effects.
Key Dates in a Stock Split
When a stock split is announced, investors need to be aware of some key dates.
- Announcement Date: The day the company officially makes the stock split public.
- Record Date: The stock split benefits will be distributed to shareholders whose names are listed on the company’s books as of this date.
- Ex-Split Date: The date on which the stock will start trading at the fresh split price.
These dates are important for investors to keep in mind when managing their investment positions.
Should You Invest in a Stock After a Split?
- Stock splits should not be the only factor that an investor considers when purchasing a stock.
- Investors should consider such things as growth, profitability, debt, competitive edge, management, and future growth prior to investing.
- A stock split can make a stock more affordable and more liquid, but it doesn’t create value for the company.
- So always make investment decisions on the fundamentals, not on the announcement of a stock split.
Frequently asked questions (FAQs)
What is the impact of a stock split on a stock’s price?
The value of the investment is not affected by the split ratio, only the share price is.
How is a stock split beneficial to investors?
A stock split may improve affordability and liquidity, but it does not increase the intrinsic value of the company or immediately increase the value of an investor’s holdings.
Does the company make more money due to the Stock Split?
No. The net effect of a stock split on a company is that it doesn’t affect its revenue, profits, earnings or financial performance.
Is it a good idea to purchase a stock right after a Stock Split?
Investors should focus on the firm’s fundamentals, valuations and growth potential and not solely on the stock split.
