Discussion Topic: Stock Split
When you start to invest in stocks, you may sometimes encounter a common scenario known as a stock split. While the new and inexperienced investors tend to mistakenly believe stock-splits as the most profitable action as it increases the number of shares they hold, but practically it's not that true.
A stock split is nothing but an accounting transaction carried out to make the nominal quoted market value of shares more affordable and increase the liquidity.
In the case of something like a 2-for-1 stock split (or 2:1 stock-split), it's same as exchanging a $20 currency note for two $10 currency note. Though you will now have more number of shares than what you were holding, the total capital value of those shares would remain unchanged as the per-share price will fall.
As an investor, you must understand the concept of stock split so that you can take a safe decision in case you encounter such situation. Here's a beginner guide to know what stock-splits are, how they happen, and how you should feel about them.
What is Stock Split? - Definition
A stock split is a corporate action to divide its existing shares into multiple shares to decrease the per-share market price and boost the liquidity of the shares. Although the number of outstanding shares increases by a specific multiple, the total capital value of the shares remains equal to the pre-split amount, because the split does not add any real value.
This is often called as the "Forward Stock Split".
The most common split ratios are 2-for-1 (2:1), 3-for-1 (3:1), and 3-for-2 (3:2). The first two ratios mean that the stockholder will have two or three shares, respectively, for every share he holds, and the third ratio means that the investor will have 3 shares for every two shares he is holding.
Why Stock Splits?
There are various reasons why a company decides to split the stocks. Some of the most popular reasons are discussed below.
The first and most popular reason for the forward stock split is to increase the liquidity of shares. Because, once the liquidity of stock increases, more buyers and sellers can trade in the stock, thus it helps to discover the true value of the company shares. Liquidity in stock will also make the trading easier for the buyers and sellers and bring down the Bid/Ask Spread.
It is also the means of making the stock more affordable to general public. This is mostly done when the price of a stock moves up significantly and goes way beyond other company's stock in the same industrial sector. In that case, a stock-split is carried out to restore the share price in a level compared with the peer companies.
For example, on 17th August 2010, the share of Housing Development Finance Corporation (HDFC) was trading at a market price around Rs 3,011.00. Then the company decided to split the share in a ratio of 5:1 and the share price become around Rs 621.20 on 18th August 2010 (post-split).
How Stock Split Works:
In case of forward stock-split, the outstanding shares of the company are divided into specific numbers of predetermined shares and the liquidity of the stock increases. The face value of the stock is also divided in the same ratio that the shares are divided into.
For example, let’s assume that a company has 1000 crore outstanding in a face value of shares of $10 per-share and market value of $50 Per share. Suppose the company announces a stock split 5-for-1 (5:1), thus the face value would now become $2 per-share ($10/5=$2) and market value would become $10 ($50/5=$10). Therefore, one share of $10 face value will become 5 shares having a face value of $2 per-share. A person holding 100 shares of that company will now have 500 shares after the stock split.
Though it looks very similar to issuing bonus shares, but it is different. See our guide on stock split vs bonus issue: what's the difference.
Theoretically, a stock-split should have no effect on a stock's capital price. But, as it often results in revived investor interest, usually it imposes a positive impact on the stock price. While this effect can be temporary, a company with strong fundamentals can be benefited from this.
If you are still unsure about how it works or don't want to do such calculations, we have developed a solution for you. You can instead download and use our "Stock Split Calculator App" to do that hardwork for you. You can calculate forward stock split and reverse stock split with a touch of a single button. Click on the App Image to download it from Google Play Store.
Advantages for Investors in Stock-Split:
There have plenty of controversies over whether a stock split is an advantage or disadvantage to investors. Some people say that a stock-split is a good buying indicator as it signifies that the company's share price is increasing, while others say that a stock split basically has no effect on the fundamental value of the stock and hence delivers no real advantage to investors.
Though we oftentimes witness a positive sentiment building around the stock split, that can be a temporary effect if the fundamentals of that company are not strong enough. Hence, before investing in a company who is undergoing a stock split, check for the fundamentals of that company.
What is a Reverse Stock Split?
Although rarely happens, it is the opposite of a forward stock split. The sole purpose of this is to raise the nominal market price of each share. The reverse stock split typically indicates a disaster or struggle with the business and usually carried out to avoid being delisted from a major stock exchange. To know more see our guide on reverse stock-split.
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