Stock Split

A stock split is a corporate action where a company divides its existing shares into multiple shares to increase liquidity and reduce the share price. In the event of a stock split, the number of shares increases, but the total value of the shareholders’ equity remains the same.

What Is A Stock Split?

A stock split is a financial strategy that public companies use to divide their existing shares into multiple shares. This process increases the liquidity of shares available while reducing the price of each share proportionally without altering the company’s total market capitalisation or value.

A stock split is done to enhance the accessibility of shares by making them more affordable to a broader range of investors, particularly those with smaller budgets. A stock split is often viewed as a positive indicator of a company’s growth and success, which can boost investor confidence and demand.

Understanding Split Ratios

Split ratios tell us how many new shares a shareholder will get for every share they own. For example, in a 2-for-1 split, a shareholder who owns 1 share will now have 2 shares. If the share price was ₹1,000 before the split, it will drop to ₹500 after the split, but the total value remains the same.

Similarly, in a 3-for-1 split, a shareholder with 1 share will now have 3 shares, and the price per share will reduce accordingly. Split ratios help companies make their shares more affordable without changing the total value of shareholders’ investments.

What Are The Types Of Stock splits?

There are two types of stock splits, each serving distinct purposes and reflecting different circumstances for the company. Here’s an explanation of both:

Forward Stock Split

This is the most common type of stock split done by companies. This is when a company increases the total number of its outstanding shares by dividing its existing shares into multiple shares. The goal is to make the stock more affordable for investors by reducing the price per share.

On October 28, 2021, IRCTC executed a stock split in a 1:5 ratio. Before the split, its share price was around ₹4,000. After the stock split, the price was adjusted to approximately ₹900, making it more affordable and accessible for retail investors.

Here is the IRCTC chart where stock rallied almost 10% on a single day

Reverse Stock Split

A reverse stock split, on the other hand, combines the number of shares by reducing the total count of outstanding shares and increasing the price per share. This is often done by companies whose stock price has dropped significantly, and they want to bring it back to a more respectable level.

Thinkink Picturez Ltd: On February 6, 2020, Thinkink Picturez implemented a reverse stock split in the ratio of 1:5, consolidating every five shares into one, thereby increasing the face value per share.

Different Types of Stock Split Ratios

Understanding the various stock split ratios helps investors know how their shareholding and stock price will be adjusted, and what to expect when a company announces a split.

Example of Stock Splits in India

Impact Of Stock Split

When a company does a stock split, it impacts shareholders, influences the company’s operations, and can also shift the market sentiment for the stock. Here is the detailed breakdown:

Effect On Share Price

A stock split increases the number of shares and reduces the price per share, but the total value of the company stays the same. Lower prices make the stock more affordable, attracting more investors and increasing demand.

Effect on shareholders of a stock split

After the stock split, the market capitalisation of the company does not change. While the number of shares increases, the price per share decreases proportionally, leaving the total value unchanged. Shareholders receive additional shares based on the split ratio. A forward stock split reduces the stock price, making it more affordable for retail investors and attracting more people to invest.

Effect On the Company Of a Stock Split

Publicly traded companies use stock splits to make their shares more accessible to a larger group of investors, especially when high share prices limit participation. After a forward stock split, the increased affordability often attracts more investors, creating upward momentum that can lead to a rise in the company’s valuation.

Positive Market Sentiment

Forward stock splits are often interpreted as a signal of the company’s confidence in its growth trajectory. Companies usually implement splits after a period of sustained price appreciation, which reflects strong performance. This optimism can attract more investors, leading to increased demand for the stock.

Impact On F&O

When a stock split happens, it affects Futures and Options (F&O) contracts as well. The lot size of F&O contracts is adjusted to match the split ratio, ensuring that the overall contract value remains the same. For example, if a stock undergoes a 2-for-1 split, the number of shares in one lot will double, but the price per share will be reduced by half. Similarly, the strike price of options is adjusted according to the split ratio.

Reason behind Companies Splitting Their Stocks

A stock split is generally done by companies to make their shares more affordable, improve liquidity, and attract a wider range of investors. Companies usually announce stock splits after significant price appreciation and strong business performance.

Here are some common reasons why companies split their stocks:

Improve Affordability for Retail Investors

When a stock price becomes very high, smaller investors may find it difficult to buy shares. A forward stock split reduces the price per share, making the stock more accessible to retail investors.

Increase Market Liquidity

Lower share prices generally increase trading activity because more investors can participate in buying and selling the stock. Higher liquidity also improves market efficiency and trade execution.

Improve Market Participation

Affordable share prices often attract new investors, increasing overall market participation and investor interest in the stock.

Positive Signal of Growth

Companies usually announce stock splits after strong price performance and consistent growth. Because of this, stock splits are often viewed as a positive sign of management confidence and business strength.

Maintain an Attractive Trading Range

Some companies prefer to keep their stock price within a certain range that is considered comfortable for retail and institutional investors. Stock splits help maintain that range without affecting the company’s market capitalisation.

Key Considerations Of Stock Split

Stock splits can affect share prices, investor sentiment, and market activity. Here are the key points to consider.

Misconceptions

One common misconception is that a stock split increases or decreases the fundamental value of a company. In reality, a stock split has no impact on the company’sintrinsic valueor its market capitalisation. The total value of shares held by investors remains the same, as the increase in the number of shares offsets the decrease in share price.

Post-Split Volatility

After a stock split, share prices may experience short-term fluctuations. This is often driven by increased trading activity as the lower share price attracts new investors, while some existing investors may take the opportunity to adjust their holdings.

Forward Split: Increased demand due to affordability can lead to a temporary rise in the stock price, creating positive momentum.

Reverse Split: A higher share price may initially improve market perception but can also lead to caution among investors, resulting in potential sell-offs.

While such volatility is common, it generally stabilises once the market adjusts to the new share price and trading dynamics.

Advantages and Disadvantages of Stock Splits

Stock splits can improve accessibility and liquidity, but they also come with certain limitations and misconceptions that investors should understand.

Advantages of Stock Splits

Improves Affordability

Forward stock splits reduce the price per share, allowing more retail investors to purchase the stock.

Increases Liquidity

A larger number of outstanding shares generally improves trading activity and market liquidity.

Boosts Investor Sentiment

Stock splits are often interpreted as a sign of strong company performance and future growth potential.

Encourages Wider Participation

Lower stock prices can attract new investors and increase overall market participation.

Better Accessibility in F&O Markets

Stock splits adjust lot sizes and strike prices in derivatives trading, making contracts more accessible to traders.

Disadvantages of Stock Splits

No Change in Fundamental Value

A stock split does not increase the company’s intrinsic value, profitability, or market capitalisation.

May Create Short-Term Volatility

Increased trading activity after a split may lead to temporary price fluctuations and speculative trading.

Can Create Misconceptions

Some investors incorrectly assume that stock splits automatically make a company more valuable, which is not true fundamentally.

Reverse Splits May Signal Weakness

Reverse stock splits are sometimes viewed negatively because they are often used by companies whose stock prices have fallen significantly.

Increased Speculative Activity

Lower share prices may attract short-term traders and increase speculative market behaviour.

How do stock splits affect my investment returns?

Stock splits do not directly affect your investment returns because they simply increase the number of shares you own while proportionally reducing the stock price, keeping the total investment value the same. 

For example, in a 2-for-1 stock split, you’ll have twice as many shares at half the price each. However, stock splits can improve liquidity and attract more investors by making the stock more affordable, which may lead to increased demand and potential price appreciation over time. It’s important to focus on the company’s fundamentals rather than the split itself when evaluating returns.

Conclusion

A stock split is a useful strategy that companies use to make their shares more affordable and accessible to investors. It increases the number of shares while lowering the price per share without changing the company’s total value. Forward stock splits are often seen as a sign of strong performance and growth, attracting more investors and boosting market sentiment. Reverse stock splits, on the other hand, are used to improve share prices when they have dropped too low. While stock splits can create short-term price changes, they don’t impact the company’s intrinsic value, offering investors the same overall holdings.

Frequently Asked Questions (FAQs)

What is meant by a Stock Split?

A stock split is a corporate action where a company divides its existing shares into multiple shares to increase liquidity and make shares more affordable without changing the company’s total market value.

How does a stock split work?

In a stock split, the company increases the number of shares while proportionally reducing the price per share so that the total investment value remains unchanged.

For example:

• In a 2-for-1 split, 1 share becomes 2 shares.
• If the original share price was ₹1,000, the new price becomes ₹500 per share.

Although the number of shares increases, the total investment value remains the same.

What does a 1.5-for-1 share split mean?

A 1.5 share split means that for every 1 share you own, you will now have 1.5 shares. This means if you had 10 shares before the split, you will now have 15 shares, but the price per share will decrease, so the total value stays the same.

Do stocks rise after a split?

Not always, but sometimes stocks may rise after a split because more investors can afford the lower price, increasing demand. However, it depends on the company’s performance and market conditions.

Is a split good for a stock?

A stock split can be good because it makes shares more affordable for retail investors and can increase trading activity. But it doesn’t change the company’s actual value or fundamentals.

Does a stock split affect face value?

Yes, a stock split reduces the face value of the stock. For example, if a share with a face value of ₹10 undergoes a 2-for-1 split, the face value becomes ₹5 per share.

How Does a Stock Split Affect Investment Returns?

A stock split does not directly change investment returns because the total value of the investor’s holdings remains the same after the split.

However, improved liquidity, affordability, and increased investor participation may positively influence stock demand and long-term price movement.