What are Stock Splits and How Do They Work?

In times when a stock price has skyrocketed, splitting it can make it more accessible to small investors. Stock splits allow companies to divide each existing share into multiple new shares without affecting their market capitalization (total market value of all their shares) or investors’ stakes in the firm. This can be a good sign for both existing shareholders and potential investors.

Here is the lowdown on stock splits and their mechanics:

What are Stock Splits?

A company has a definite number of shares in its share capital, each with a specific face value. Stock split refers to a decision made by the Board of Directors of a company to increase the number of shares by reducing their face value proportionately.

Companies can split a stock as many times as they choose, supplemented with ratios like “2-for-1,” “3-for-1,” or even “100-for-1.” Then they report how much an individual share is now worth. Splitting a corporation’s stock does not dilute ownership interests of current shareholders. Unlike issuing new shares, a stock split does not change an existing shareholder’s equity.

For instance, after a two-for-one stock split, someone who owns 100 shares at INR 100 per share will own 200 shares at INR 50 per share. If the company pays dividends, you will also receive proportionate dividends per share. This year, IRCTC opted for a stock split in the ratio of 1:5 where the total number of shares increased 5 times while decreasing the share price.

How does Stock Split Work?

In a stock split, the shares with a face value of INR 10  would reduce to INR 1 in a 1:10 split. That way, investors will have 10 times the initial number of shares held. Prices would also drop proportionally, but the total value of their holding remains the same.

However, the price of a stock tends to increase following a stock split in the future, since the stock appears to be cheaper now. This creates a higher demand from small and retail investors. Furthermore, it creates a more positive attitude towards investing in companies as the stock price, which was previously very high, becomes achievable.

Rationale Behind Stock Split

Here are some of the reasons companies go for stock split:

• Increase in liquidity: Share splits are a common way to reduce the value of a stock that may be too expensive for investors to purchase and further price increases can discourage them from participating. By lowering the value of a stock through a split, the shares are more accessible to all.
• Build a stronger stockholder base: Following an initial public offering (IPO), companies often issue more shares to the public, but these can lead to stock dilution. In the case of a stock split, the increase in outstanding shares of a company allows more investors to purchase shares, increasing the company’s stockholder base.
• Growth outlook for the future: Investors have a perception that companies that split their shares have plans for future growth and are thriving, and this belief creates a positive image of the company in the marketplace.

Read more: ESOP pool – How Much Equity Should Be Diluted?

Stock split vs. Stock Dividend

Stock split increases its number of outstanding shares in the same way as dividends do, but the two actions are very different. When a company splits stock, it divides its current shares into more shares, thereby increasing its outstanding shares by a predetermined ratio. This causes a decline in the share price.

However, stock dividends are fixed amounts of shares paid to existing shareholders in exchange for cash dividends. They also increase the number of outstanding shares and lower the share price proportionally.

What are reverse stock splits? 

Also known as stock mergers, reverse stock splits are like regular stock splits but with the opposite workings. In contrast to a regular stock split, a reverse stock split yields fewer shares and increases the share price. Reverse stock splits, in contrast to regular stock splits (that generally occur when a company is doing well), are sometimes triggered by distressed companies. (Read more: Common Stocks vs Preferred Stocks: What’s the Difference?)

For instance, an investor owning two shares would receive 1 share for every two shares they currently hold in a 2:1 reverse stock split. Here are some of the effects of reverse stock splits:

• Reduce number of shareholders
• Attract larger investors
• Increase share price
• Avoid being delisted
• Appear more credible

Takeaway

Stock splits suggest a company is doing well, making it a good investment.The lower price per share also allows you to purchase more shares, as it is more affordable. Large companies often opt for stock splits to make their stocks more accessible to retail investors.

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