Stocks Markets

Why Do Companies Split Shares?

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Has a firm in which you have invested or were hoping to invest shortly split shares, causing the prices to drop suddenly? Now, you are uncertain about your position. Then, this article will give you an overall idea of the motive behind the stock split. Also, determine how it can affect your investments so that you can plan your future investment strategies accordingly.

Any investor desires a stock that can generate generous returns on its investments. But it is often observed that even a stock with good prospects is challenging for an average investor to invest in, owing to its high share price. This kind of market condition often leads to companies splitting their shares and increasing the affordability of the share.

What Is A Stock Split?

Any publicly listed company has a fixed market capital equally divided in its outstanding number of shares. Also, every company is associated with a face value, which is its original value. A stock split is a corporate decision taken by a firm to increase the number of outstanding shares in a fixed ratio, keeping the market capital constant. In the process, the face value and stock prices simultaneously decrease in the same ratio.

For example, let there be a firm A with a face value of Rs 100 and an outstanding number of shares of 1 million. Now, the board of directors of A has decided to split shares in a ratio of 10-for-1 split. So, the outstanding number of shares of A now becomes 10 million. The investors end up with 10 times the number of shares they had before, while the face value and current trading value of A fall 10-fold to Rs 10. The market capitalisation of A remains the same as before the stock split.

The most common split formats are 2-for-1 and 3-for-1, where the investors end up with twice and thrice the previous number of shares, respectively.

Motive Behind Companies Splitting Their Shares

Sometimes, a company’s share price increases way too much, concerning its peers in the same industry, and the share’s affordability is compromised. This might make an investor uncomfortable and unsure of his investment choices. This is when a company’s board of directors decides to split stocks. Such a decision increases the share’s affordability while keeping the company’s underlying value constant. This helps new investors take investment entries in the firm and encourages existing investors to hold their shares and invest more. Split stocks also help to boost the share’s liquidity.

Another advantage of companies splitting shares is that sometimes it also leads to price hikes in the after-split share prices. When a share already has good prospects, and a share split occurs, many investors think that a share is now traded at a much lower and more affordable price. They assume that the firm’s growth will continue in the future. Therefore, the increase in demand for the company’s shares ultimately causes the share prices to rise.

Consequences Of Split Shares

  • Increased liquidity: When transactions for a stock become more manageable, it is said to have greater liquidity. Stock split leads to decreased stock prices, which eases the trading process for the investors. It also becomes easy for new investors to enter the company and for existing investors to hold on to their shares and even increase their holdings.
  • Increased market capitalisation for the firm: In several cases, stock splits lead to an added market capitalisation, even if the shares split has no direct effect on stock prices. This is generally on account of increased demand due to the more attainable prices, attracting smaller new investors. As new and existing investors obtain more holding, it increases share prices, thus increasing the firm’s market capitalisation.
  • Increased Volatility: Volatility in the stock market is the rate at which a firm’s stock prices fluctuate over a given period. Stock splits often lead to increased volatility in share prices. But why so? Investors take entry into the stock for a short-term gain because of this. Unlike long-term investors, they exit after taking a steady profit, causing the prices to fluctuate after the exit. Thus, a share split might lead to the entrance of the wrong pool of investors, causing increased volatility in the share prices.

How Does A Stock Split Affect Your Investments?

A stock split doesn’t change the net value of your investment in the firm. You might have more shares, but since the share prices drop accordingly, net investment remains constant. If you are not an investor looking to take a holding in the firm, the decreased affordability can be a chance for you. On the other hand, more investors like you will be strengthening their holding due to the lower prices; thus, the stock prices might go up.

Similarly, for the short sellers, there are no direct added gains, and the share split doesn’t affect the overall value of your position.

What Is A Reverse Stock Split?

A reverse stock split is simply the opposite phenomenon of a stock split. It merges multiple less-valued stocks to get a more-valued store. Like split shares, there is no change in market capitalisation. At the same time, the current trading value and the face value of the firm increase. Companies use this tactic to often increase their brand’s prestige by increasing the share price. Split shares are traded at a lower value than the original share.

Final Thoughts

A stock split doesn’t necessarily directly affect the firm’s share prices or the current investors. It does increase the number of outstanding shares and decrease the current trading prices, increasing the affordability for new investors. Still, it doesn’t change an investor’s overall holding in the firm. To read more such articles and explore different concepts of the stock split, visit Piramal Finance.