A stock split is a decision by a company to increase the number of its outstanding shares by issuing more shares to existing shareholders. For instance, in a 2:1 stock split, every shareholder with one share is given an additional share. If the company has 20 million shares outstanding with a face value of R10 before the stock split, the number will rise to 40 million shares with a face value of R5 each after the split.
An individual investor having 100 shares with a face value of R10 each before the stock split will have 200 shares with a face value of R5 each after the split. In other words, it is like cutting a 14-inch pizza into eight slices from four slices earlier. Why do companies go for a stock split? What are the
benefits for investors? Is a stock split and a bonus issue the same thing? Let?s take a look.
Why companies split stock
The major motivation behind the move is to increase the liquidity of the company?s share in the market. Suppose the price of a well-known software company, IJK, reaches R4,800 a share (with a face value of R10) whereas its peer, TUV, trades around R2,200. Here, though IJK could be a strong company, it may not be affordable for many small investors. By splitting the IJK stock 2:1, the share price comes down to a more affordable level, i.e., R2,400 (or R4,800/2). With an increase in liquidity following the stock split, more buyers and sellers buy and sell the shares. The market capitalisation of the share does not change, but the lower price attracts more investors; even existing shareholders feel they have more shares than earlier.
The effect is psychological in nature. If the stock rises, the existing shareholders will have a greater number of shares to trade in the market.
What?s in it for you
Corporate finance literature is divided on the issue. One side of the argument is that a stock split is a good signal, indicating that the company?s share price is rising and, therefore, the company is doing well. The counterargument is, a stock split has no effect on the performance or fundamentals of the share and, hence, it is of no advantage to the individual investor. Both arguments are supported with empirical evidence but, in reality, a stock split boosts positive sentiment in the markets. The share price of a company usually goes up after a stock split as the demand for shares increases. More investors would want to buy the stock since they can afford it now.
Stock split vs bonus issue
Don?t confuse the two. Bonus shares are issued when the reserves and surplus (past profits) increase and the company wishes to convert them into shares. These shares are given to investors free of cost. So, when an investor gets a bonus, the number of shares he owns increases without any cost.
A stock split is somewhat like a bonus issue, wherein when a R10 stock is split into two R5 shares, the number of shares an investor holds doubles at no extra cost to him. But that is where the similarity ends. A bonus is a free additional share. A stock split is the same share split into two. In a stock split, the number of shares increases but the face value drops. The face value never changes for a bonus share.
To conclude, a stock split has no effect on a company?s net worth. But a stock split alone should not be the deciding factor to buy a stock.
n The writer is associate
professor of finance and
accounting at IIM Shillong