Introduction
Before understanding the impact of stock split, let us take a quick moment to get a general introduction to this term. Also as a bonus content, we will also get answers to why companies opt for it.
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What is Stock Spilt
As the definition goes, stock split is a corporate action, where a company decides to split its shares into multiple shares. It is generally demonstrated as X:Y, where for X number of stocks are provided against every Y stocks held by the investor.
For example, consider a company with a total of 10 lakh shares trading in the market, undergoing the following scenarios:
The company undergoes a stock split of 2:1. This means that for every two stock held by the investor, one more additional stock is introduced. Now, the revised values of the total shares will be 20 lakhs.
Stock Split: Corporate Action
Now it is important to understanding the main distinction of a stock split as a corporate action.
When the quantity of the stocks are increased in the market, does it mean that the market capitalisation will also increase?
The answer is No.
When the stocks are split, the current market price is proportionately reduced, keeping the market capitalisation constant.
For example, consider Company A has total 10 lakhs shares trading at Rs. 500 each. Thus, the market capitalisation of the company will be Rs. 50 Crores (Total 10 lakh shares * Rs. 500). When the company opts for 1:1 split, this means for every one share, a new one is introduced.
After this stock split, the revised total number of shares will be 20 lakhs. But since the market capitalisation has to remain constant, the revised current price of the stock will also get reduced to Rs. 250 per share.
- Before: Total 10 lakh shares of Rs. 500 each, making a market capitalisation of Rs. 50 Crores.
- After: Total 20 lakhs shares of Rs. 250 each, again making a market capitalisation of Rs. 50 Crores.
Therefore, stock split does not enhance the valuation of the company, rather just fragment the a single value stock into multiple parts.
Impact of Stock Split
Impact on Market Capitalisation of the company
Even though the quantity of the stocks increases as a result of a stock split, there is no change in the market capitalisation. The increase in stock quantities causes a proportional reduction in stock prices to maintain a constant market capitalisation.
Impact on Face Value of the company
Due to the implication of stock split, the face value decreases, just like in the case of stock price. When the total quantity of stocks is increased, the face value of each stock will proportionately be reduced.
Impact on Total Shares of the company
Stock split increase the quantity of open tradable shares in the markets. As there are more shares of the same company at much lower price, the liquidity of the stock increases and more investors can now participate in investment.
Impact on the Total Value of the Investment of Shareholder
As a result of increase in total shares and simultaneously decrease in the market price of the stock, does not impact on the total value of the investment.
Summarising the Impact of Stock Split
| Impact Particular | Value Change |
|---|---|
| Market Capitalisation | Unchanged |
| Face Value | Decreases |
| Total Shares | Increases |
| Investment Value | Unchanged |
Common Stock Split Ratios
Consider a stock with total 10,000 shares, each having a current market price of Rs. 200. The market capitalisation is at Rs. 20 lakhs.
- 2:1 – Total 2 stocks are provided for every 1 stock held by the investor. Thus, the revised total shared will be 20,000 and the market price will be Rs. 100.
- 3:1 – Total 3 stocks are provided for every 1 stock held by the investor. Thus, the revised total shared will be 30,000 and the market price will be Rs. 66.67.
- 3:2 – Total 3 stocks are provided for every 2 stock held by the investor. Thus, the revised total shared will be 15,000 and the market price will be Rs. 133.33.
Understanding the scenario with an example
Consider a company ABC Limited with a 10 lakh shares trading in the market. The current price of each share of the company is Rs. 500 and the Face Value of the company is Rs. 10. The market capitalisation of the company is Rs. 50 Crore. Consider the stock has undergone a 3:1 Stock Split Ration.
| Particular | Before Stock Split | After Stock Split |
|---|---|---|
| Market Capitalisation | Rs. 50 Crore | Rs. 50 Crore |
| Total Stocks | 10 lakhs | 30 lakhs |
| Market Price | Rs. 500 | Rs. 166.67 |
| Face value | Rs. 10 | Rs. 3.33 |
Why do companies opt for stock split
The following are the major reasons why companies opt for stock split:
- Increase the stock liquidity
- Attract more investors
- Fixing share price
Increase the stock liquidity
A stock split increases the total tradable quantities of a company’s shares, resulting in a reduction of the market price per share. This created an entry barrier for investor to easily enter and exit the investment. Thereby, increasing its liquidity.
Attract more investors
As the prices are reduced, new investors with low capital can now invest. This could further drive the demand and infuse more money in the stock to raise the prices higher.
Fixing share price
Certain companies are of the view to keep the prices of their stock in a certain range in order to maintain its liquidity. As over time, the prices of the stock surpasses those ranges, the companies declare a stock split and bring down the prices in the defined range.
Over a long course of investment, the stock prices remain in a defined range, but the quantity of the stock keeps on increasing, thereby increasing the investment value to the investor.
Conclusion
Many a times companies incorporate stock split in order to drive the stock prices higher of the company. More quantity of shares means lower / attractive prices and easier entry barriers for investors to enter.
Stock split makes the investment opportunity available for smaller investors, thereby increasing the demand and driving the prices higher.
