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How does a stock react when the demand for it is high? Like every other product or service, stocks of companies follow the usual economic rule where the demand and price are directly proportional, whereas the supply and price are inversely proportional.
Increasing stock prices, though a sign of growth, can be a matter of concern since the shares may not be affordable to a substantial portion of investors. This will indeed impact the demand for the stock. To handle this scenario, companies resort to stock splits.
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What is a stock split?
A corporate action where a company reduces the price per share by splitting its stocks i.e., increasing the number of units of shares, is called a stock split.
The increase in the number of units and the price reduction is proportional, because of which the market capitalisation of companies remains unaffected.
The process of splitting stocks
Liquidity is one of the most essential features of a stock from the perspective of the investor and the owner company. Liquid stocks are usually prone to lesser risks as they can be converted into cash in a short span.
The stock splitting action allows companies to provide this feature to their investors by reducing stock prices, eventually increasing the demand.
Different companies use different ratios to split their stocks, while one of the most popularly used ratios is a 2-for-1 stock split (2:1).
So, if a company splits its stocks in the ratio of 2:1, it means that every shareholder will get two shares per share held and the price per share will go down two times its current price. The market capitalisation will remain the same, but the number of outstanding shares in the market will increase by two times due to the stock split.
Also Read: A beginner’s guide to the stock market
Stock split example
Consider a company, ABC, with a market capitalisation of ₹ 1,20,00,000. Currently, the company has 10,000 shares outstanding with a value of ₹ 1,200 per share. Since the price was getting unaffordable to people, affecting the stock’s liquidity, they announced a stock split in the ratio of 3:1.
Upon splitting, the number of shares outstanding is 30,000 (10,000 *3), and the value per share is ₹400.
The market capitalisation after the split is still ₹ 1,20,00,000 (10,000 * 1,200). But, the share price has reduced making it more affordable, and the liquidity has increased due to which the shares are readily available for trade.
A recent real-world example of a stock split is that of BCL Industries.
In May 2023, BCL Industries announced a stock split in the ratio of 10:1.
The board of directors decided to do so to boost the stock’s liquidity. With a market capitalisation of around ₹1,195 crores, BCL Industries will issue 10 shares for every share held by its investors on the record date.
Impact of share split on investors
Stock splits do not have any significant impact on existing investors. Since there is no change in the net worth of shares held, existing investors do not gain or lose from stock splits. However, it has an impact on potential investors who are planning to invest in the stock.
The general psychology of regular investors is that buying 100 shares of ₹10 each is better than buying one share of ₹ 1,000.
Advantages and limitations
Benefits of stock split:
- The primary purpose of stock splits is to give the benefit of liquidity to companies, along with making it accessible to a wide range of investors.
- Stock splits increase the interest of investors in a company’s stock leading to an increase in demand. It will again lead to share prices going up, which increases the goodwill of the company.
- A stock split is usually seen as a positive corporate action as it indicates a company’s growth.
Cons of a stock split:
- A stock split is an expensive affair. It involves a lot of regulatory and legal aspects because of which this corporate action is costly.
- Stock splits are sometimes viewed as worthless actions as they do not add any real value to the company’s monetary worth.
- Stock splits can often mislead and create confusion in the minds of investors.
Stock split in financial management is a significant concept for investors and companies. Though it does not practically impact the value of investments from the investor’s perspective, stock splits have a large influence on investors who are tracking a particular stock and hoping for its prices to reduce.
Yes, a stock split is generally seen as a sign of growth. When the stock prices increase continuously and become unaffordable to the public, companies split stocks. The increasing price shows high demand and growth of the stock.
Stock splits do not impact the investment value of existing shareholders. So, selling it due to the announcement of a split may not be necessary. The demand for stocks may increase after the split. This increases the price, which will increase your investment value.
Stocks may go up after a split. Even though the price per share comes down, it becomes relatively cheaper and more affordable. So, with more investors coming in, the price may increase, too.
As the name suggests, a reverse split is the reverse of a stock split. It is where multiple shares are combined into one. This is usually done when the company’s share prices are too low. Companies merge shares to increase the share price to avoid being listed. Hence, this is a negative sign.
1 for 20 is a reverse split ratio that suggests, 20 shares being combined into 1, after the corporate action. So, if one share was valued at ₹10, it becomes ₹200 (20*10) per share after the reverse split.