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Unraveling stock splits

Jul 6, 2004

Largely, it has been good time for corporates and consequently, their listed equities, across the globe over the last couple of years. Strong economic growth, especially among emerging economies, led by robust corporate performances has pushed stock prices to substantially higher levels. There has been largely a favourable outlook towards equities, notwithstanding the hic-cups that keep surfacing every now and then. And it is during these times that corporate announcements with respect to stock splits and bonus issues tend to come to the fore again. In this article, we shall try to throw some light on the aspect of stock split and how an investor/ company is affected by such an action.Stock splits:

It must be noted that every equity share of a company has a certain face value, which could be anything ranging from Re 1 to Rs 1,000. But the most common face values in India are Re 1, Rs 5, Rs 10, and Rs 100. What the stock split does is basically divide the face value of the shares to some smaller face value, which is consequently reflected as a proportionate reduction in the price of that particular stock. For e.g. when a company X announces a stock split of 2:1, it means that the every one share held by the shareholder will be converted in to 2 shares of the company. But since this is a stock split, reducing the current face value of the share by half will produce the additional share. This will consequently reduce the stock price also by half. What this basically implies is that the company's equity base does not undergo a change. And since the equity base is constant, the market capitalization of the stock also remains stagnant since if the number of shares has doubled, the stock price has halved. Let us see with an example how are the two parties in this process affected.

An investor:  Mr. A had 100 shares of company X at a face value of Rs 10 per share and a total investment of Rs 10,000, assuming a share price of Rs 100. Post the 2:1 stock split, Mr. A will have 200 shares of face value Rs 5 each, while the market price of the shares also halve to Rs 50, thus keeping his total investment at Rs 10,000.

The company:  Company X had 100 m outstanding shares of face value Rs 10 each. The share price currently being quoted on the stock exchanges is Rs 100 thus making the market capitalization of the stock at Rs 10 bn (outstanding shares x share price). Further, post-split, while the company's outstanding shares would increase to 200 m with shares having a face value of Rs 5. Owing to the share price reducing by half to Rs 50, the market capitalization would continue to remain at Rs 10 bn.

Why the process of stock-split?

The basic premises of carrying out a stock-split are two:

  • Increase affordability:  One key motive is to increase the affordability of the stock and bring it within the reach of a common man. This is because, over the years, the markets reward a company, which has been performing well, and their stock price tends to command higher valuations. Thus, a company with a face value of Rs 100 and a stock price of Rs 5,000, when it undergoes a stock split of say 10:1, the face value is reduced to 1/10th of the current and thus the price comes down to Rs 500 per share with a face value of Rs 10 per share. This effectively brings the stock within reach of a higher number of investors. This leads to higher liquidity of the stock, which is the second motive for the company taking this step.

  • Increase liquidity:  As has been above, stock split leads to an increase in the number of shares available in the market, without affecting the company's equity capital and/or market capitalization. The increased liquidity will attract more/larger investors who were considering the stock, thus making the stock more attractive owing to larger investor participation. It must be noted that liquidity is an important factor to be considered while investing in the stock of a particular company. This is because if the liquidity is low, the stock will be prone to sharper bouts of volatility, as even a small quantity of purchase/sale of shares could lead to a sharp rise/fall in the stock price owing to lack of equal participation from the other side.

Conclusion:

Since the stock split has no fundamental effect on a company or its valuations, an investor must not base his decision on the basis of this. It is status quo for the company on the basis of fundamentals and valuation in the post-split era. Thus, the general factors like the growth prospects of the company, management capability, business model, etc. should continue to remain the deciding factors while making an investment decision.


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