Significance of Stock Split

Introduction

A stock split is a corporate action in which a company divides its existing shares into multiple shares to boost the liquidity of the shares. Let us discuss what is stock split, why it is done, what are the impacts and the significance of stock split from company’s as well as investors’ perspective etc.

What is Stock Split?

  • All the public companies that are listed on stock exchanges have a definite number of outstanding shares available for trading.
  • A stock split is a decision taken by the board of directors of a company to divide its existing shares into multiple shares. In simple words, The process of dividing the outstanding shares into further smaller shares is known as stock splits.
  • In this the market value of the total outstanding shares of a company remains the same but market value of a single share is reduced in proportion to the no of shares extracted out of a single share.
  • Thus, although the number of shares outstanding increases by a specific multiple, the total value of the shares remains the same compared to pre-split amounts, because the split does not add any real value.
  • The most common forward split ratios are 2-for-1 or 3-for-1, which means that the stockholder will have two or three shares for every share held earlier.
  • Reverse stock splits are the opposite transaction, where a company divides, instead of multiplies, the number of shares that stockholders own, raising the market price accordingly.
  • People often confuse bonus shares with stock split. Distribution of bonus shares only changes its issued share capital whereas stock split splits the company’s authorized share capital
What is Stock Split?

Example of Stock Split

Example 1
  • To explain stock split further, consider the example of Stock split done by SBI in November 21, 2014.
  • Share price of State Bank of India closed at Rs 2920.9 on November 20, 2014 and on the next day (November 21, 2014) it closed at Rs 297 after the stock split as it announced a stock split of 10:1.
  • The only main reason that stock splits are done is to attract new investors and increase liquidity of the shares in the market. Value of the company does not change at all.
Example 2
  • To explain this, consider one more simple example continuing the previous example. Assume that there are two investors Harish and Aman. Both wanted to make an investment of Rs 300,000 in SBI.
  • Harish bought the shares on Wednesday which was the last day before the split date. Harish ended up buying around 103 shares at a price of Rs 2,900 per share, with Rs 1300 left from his available funds of Rs 300,000.
  • Second investor Aman thought he was smarter and waited for the stock to split and bought it on Thursday. For the same amount of Rs 300,000, he could buy 1034 shares at Rs 290 per share and is left with only Rs 140 left with him out of the total fund of Rs 3 lacs. In this way, stock split gives enormous liquidity, especially for retail investors.
  • But by the end of the week when Harish checked his Demat account, it would show that he holds 1030 shares of SBI rather than the 103 he bought, but his holding value will be the same as earlier. This is because of the fact that shares of all the shareholders would be split in the same ratio without impacting the value of holding, irrespective of the date of purchase.

Why Do Companies Split stocks?

  • A stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector. That is the company finds that the liquidity of its stock in the market is very less due to high value of its stock.
  • The primary motive for stock split is to make the stock more affordable for the small retail investors. It, thereby increases the investor base. This results in a renewal of investor interest of the company which has a positive effect on the share price in the short term.
  •  A retail investor generally doesn’t not prefer trading in a highly valued stock and lowering the stock value helps increasing the stock liquidity.  This has the practical effect of increasing liquidity in the stock. However, the underlying value of the company does not change.
  • Stock Split is done to enhance the liquidity in the market as the number of shares is increased. High liquidity results in an efficient market with the low bid-ask spread.

We have many companies trading at very high prices. Consider Eicher motors trading at Rs 20015, MRF trading at Rs 54628 or Bosch India at 16948 (as on 13.06.2019). So, let us also try to understand why many companies don’t go for stock-split even when their shares are trading at very prices. Main reasons behind this are:

  1. Institutions play a major role nowadays and for them it doesn’t really matter if they are buying a share at Rs 250 or Rs 25000.
  2. When a stock price is really low, it invites a lot of day-traders, increasing the volatility. When the share price is kept high, there is a slightly less volatility from high frequency trading.
  3. It increases buying and selling cost, because of spread. (Spread means difference between buying quote and selling quote) because higher valued stock have lower spread. Today you will find in Bosch Buying quote of Rs. 25000 and selling quote of Rs. 25003 but you won’t find any company’s quote for buying Rs. 250 and Rs. 250.03 for selling because minimum tick size is 5 paise. 
  4. Sometimes management thinks that stock split doesn’t make any difference to company’s performance or company’s valuation.
  5.  It is bit of attitude issue too. If a company split its share by 10:1 than stock prices will come from say Rs 2500 to around Rs.250, but that makes it an ordinary company in the eyes of a lay man. Today Bosch / MRF get difference respect due to their share prices. Also, notice that in 90’s Cipla’s share prices were higher than Bosch but it gave huge bonus and stock split. Today, people don’t see Cipla something very different from Ranbaxy / Sun Pharma / Lupin / Wochard of the world. 

Impact of Stock Split

Stock splits are generally done in bull markets, as many shareholders will want to retain the wealth and even see an increase in the share price, mainly caused by increased liquidity and demand of the stock.

  1. Share Price : When a stock splits, it can also result in a share price increase following a decrease immediately after the split. Since many small investors think the stock is now more affordable and buy the stock, they end up boosting demand and drive up prices. Another reason for the price increase is that a stock split provides a signal to the market that the company’s share price has been increasing and people assume this growth will continue in the future, and again, lift demand and prices.
  2. Market Capitalisation : Fundamentally speaking, value of the company or market capitalisation of the company does not change after a stock split.
  3. Earnings per Share : Financial ratios get adjusted according to the number of outstanding shares. So, if a stock had an earnings per share (EPS) of Rs 90 before announcing a 10:1 split, the new EPS for the company will be adjusted to Rs 9.
  4. Dividend per Share : Dividend for every share (dps) will also reduce proportionately after stock split. But things in the vibrant stock market can be different.

Significance of Stock Split for Company & Investors

For Company :
  1. In case of forward stock splits, the number of shares increases hence the ownership base of the company increases. The shares can now be owned by a wide range of investors.
  2. Liquidity of the stock increases, thereby increasing the market efficiency of the stock.
  3. There is no change in Authorised and Issued capital of the company as it remains the same.
  4. In case of reverse share splits, the company can sideline penny stock traders as the price of the share increases.
For Investors :
  1. In case of forward splits, shares are now more affordable to investors. Those who are already invested does not benefit apart from an increase in a number of shares, however since the price of share also decreases, the overall value for them remains same.
  2. Future Earning per share (EPS) may reduce as numbers of shares are increasing. However, for existing investor, there may not be any impact as his existing numbers of shares are also increasing.
  3. For a Share split of a blue-chip company, there is a positive perception about further growth of the stock price to pre-split levels during the growth phase of the company.
  4. Share splits are tax neutral. There is no flow of money during share splits hence there are no tax implications due to this.
  5. In case of reverse stock splits, investors need to judge the reason for the same and if the same is for avoiding delisting of stock from the exchange, it may be perceived as negative.

What Should the Investors Do?

  • We advise investors to not just go and buy the stocks going for split. While a split makes the stock more affordable for investors, they should also look at the company’s fundamentals before putting in their hard earned money in the stock. They must carefully look at a proportionate growth in the bottom line (Profit After Tax) of the company before investing in such stocks. 
  • “What really creates wealth for the shareholders is not bonuses and splits. A split or bonus with a consistent growth in the bottom line is what investors should look at before investing in such counters.