Stock split: Is it good for me?
It is likely that you may have stopped yourself from buying a company’s shares due to the price being too high. Turns out that some companies don’t want to turn away public participation due to this, so they may decide to do a stock split. In this article, we will throw some light on what stock splits are and whether they are good for you.
Before everything else, let’s formally define the term stock split.
A stock split is a corporate action through which a company divides its existing shares into multiple shares. All that means is that the stock you presently hold splits and multiplies in number.
This is similar to when you exchange one of your Rs.2000 notes for 10 notes of Rs.200. All that is changing is the number of notes you have; it does not impact the inherent value of your notes.
Companies announce a stock split in some ratio. If a company announces the stock split in the ratio of 10:1, it would translate to every 1 share you hold becoming 10 shares.
As an example, if you held 100 shares in a company and it announces a split in a 10:1 ratio, then your 100 shares become 1000 shares as a result of this split.
The face value of the stock gets split in the same ratio as well. So, if the face value before the split was Rs.10, it become Rs.1 after the split due to the 10:1 ratio.
Let’s understand the impact a stock split has on the stock price and the market capitalization of a company through a simple example.
Assume that there exists a company which has 10 lakh shares outstanding in the market with the price per share being Rs. 100. Therefore the market capitalization of the company is 10 lakh shares multiplied by Rs.100, which is Rs. 10 crores.
Assume that you own 100 shares of this company with the price per share being Rs.100, so the net-worth of your portfolio is Rs.10,000.
Now this company announces a stock split with the split ratio being 2:1.
Due to the split, you now own 200 shares with the price of each share reducing to Rs.50. Notice that the net-worth of your portfolio remains the same as before, Rs.10,000.
The split has also doubled the number of shares outstanding in the market to 20 lakhs with a proportionate reduction in the price per share to Rs.50. If we were to calculate the market capitalization, it would be 20 lakh shares multiplied by Rs.50, which is Rs. 10 crores, which is also the same as before.
All in all, a stock split results in an increase in the number of shares and proportionately reduces the price per share, without impacting either the market capitalization of the company or the net-worth of your portfolio.
Additional Read: Types of equity trading
Now let’s understand why a company would do a stock split and how this would impact you as an investor.
As we discussed in the beginning, many a times smaller investors stop themselves from buying the shares of a company because the price is too high.
To counter this, a company may announce a stock split which results in a reduction of the price per share thereby making it more affordable to buy. This in turn helps the company in expanding its shareholder base.
This results in an increase in liquidity of the shares because after the split there are more outstanding shares in the market, which translates to a potential increase in the trading volume and market activity.
All of these factors result in an increase in the demand for the stock, which then potentially ends up increasing the stock price after the split. If this were to happen, then the net-worth of your portfolio would increase as well.
On the other hand, it is also possible for a company to never announce a stock split to create a premium space for themselves and their shareholders. One of the most prominent examples of this would be MRF Ltd which has never announced a stock split. Its stock used to trade around Rs.500 in 2000-2001 and presently, it trades at around Rs.82,000.
To conclude, it can be said that the decision to do a stock split and subsequently increase the liquidity of the stock lies entirely in the hands of the company.
Additional Read: Taxation on equity investments
So, let’s summarize everything we have covered:
- In a stock split, the stock which you presently hold splits and multiplies according to some ratio announced by the company.
- In a stock split, the number of shares increase alongside a proportionate reduction in the stock price.
- Stock splits have no impact on either the market capitalization of the company or the net-worth of your portfolio
- The primary reason behind doing a stock split is to increase the liquidity of the shares and make them more affordable to smaller investors.
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