Stock splits help make shares more affordable for market participants and provide greater marketability as well as liquidity, thus leading to price discovery
For the year ended March 31, 2017, as many as 53 companies which are listed on Bombay Stock Exchange had gone for a stock split against 55 in the previous year ended March 31, 2016. One can observe that after the stock split, the market price of the concerned company’s shares comes down generally as per the proportion of the split. So, let us understand what stock split is, why do companies go for it what is the impact of the same from the investor’s point of view.
What is stock split
A stock split is nothing but the issue of new shares in a company to its existing shareholders in proportion to their current holdings. The decision to go for a stock split is taken by the company’s board of directors. For instance, in case of 1:1 stock split, an additional one share is given for each one share held by a shareholder. In this process, the number of shares outstanding in the market goes up whereas the market capitalization of the company remains the same. As the number of shares outstanding goes up, price per share comes down.
Motivation for stock split
A stock split is generally opted by the board of director of a company when its share price increases to levels that are either too high or are beyond the price levels of similar companies in their sector. The major motive is to make shares more affordable to small investors even though the underlying value of the company has not changed.
Stock split leads to price discovery
A stock split could result in a share price increase following the decrease immediately after the split. As many market participants, including small investors, think the stock is now more affordable and buy the stock, this can enhance the demand and drive up the price. Another reason for the price increase is that a stock split provides a signal to the market that the company’s share price has been increasing and people assume this growth will continue in the future, and again, push up demand and thus, prices. This concept is known as price discovery. When more participants buy and sell the shares of a company, the true and fair value of the share can be arrived at.
Reverse stock split
Reverse stock split is the modified version of a stock split. As stock exchanges delist shares if they fall below a certain price per share, companies with low share prices that would like to increase their prices to either gain more respectability in the market or to prevent the company from being delisted use this mechansim. For instance, in a reverse 1-for-5 split, 10 million outstanding shares at 50 paise each would now become two million shares outstanding at `2.50 per share. In both cases, the company is still worth Rs 5 million.
To conclude, stock split is used primarily by companies that have seen their share prices increase substantially compared to that of their counterparts. Though the number of outstanding shares increases and price per share decreases, the market capitalisation does not change. As a result, stock splits help make shares more affordable to market participants and provide greater marketability as well liquidity thus leading to price discovery.
The writer is professor, School of Management & Commerce, Central University of Tamil Nadu