What is a stock split?
A stock split is a company’s decision to increase the number of shares so that each share becomes worth less, but does not increase the total value for all shares.
For instance, if you own one share, a stock split means that you may suddenly find that you own two or three shares at lower prices instead, say, in a two-for-one split, where each share is divided into two; thus, if you had one share, you now have two, but its value remains exactly the same.
This is primarily to make the stock more attractive and affordable to new investors by lowering the price per share, thus increasing its liquidity.
More importantly, though, the overall value of your investment and your stake in the company does not change with regards to the increase in shares.
Reverse stock split
The opposite of stock split is what actually occurs in a reverse stock split, the number of shares is reduced so that the price per share is increased.
How it works?
Normally, after a stock split, new shares are credited to the investor within two days.
With two types of stock splits-regular stock split and reverse stock split-a company can control its share price.
Regular stock split occurs when the company issues new shares to the existing shareholders, resulting in a rise in total shares outstanding.
This ultimately leads to a decline in the natural price per share, making it relatively cheaper for smaller investors.
During this period, the per-share price declines but with no change in the overall value and market capitalization of the company.
Reverse Stock Split decreases its outstanding shares in a reverse stock split, whereby the per-share price increases.
Example:
Assume you had 10 shares at Rs. 4 each. If a company does a 2-for-1 reverse split, you would end up with 5 shares at Rs. 8 each.
The sum of investment would still be worth Rs. 40, even though now you have lesser shares. In any scenario of either a regular or reverse split, the value of your investment remains the same.
Advantages of Stock Splits
1) Boosts Liquidity
Since there are more stocks available in the market, it’s easier to buy and sell in an after-split market.
Higher volumes in trading make the stock relatively more attractive to the investor since it can be easily entered or exited positions with minimal effects on the stock price.
2) Attracts New Investors
A stock split decreases the price of shares individually. Consequently, it might attract investors who initially considered the stock too expensive. It may be able to contact an increased number of potential investors at the new reduced price point and therefore create a high demand for shares.
3) Makes Shares More Affordable
Stock splits lower the price per share, thus making the shares look more affordable. For instance, if a share went at $300 before a 5-for-1 split was done, it will be sold at $60 after such a split. It might attract smaller investors who would not have afforded it at the prior price.
4) May Increase Market Cap Over Time
Though a stock split does not immediately increase the market value of the company, it can sometimes indirectly force the stock price upward over the long run if more investors are attracted to it. The increased demand may gradually see the stock’s market cap move upward.
Disadvantages of Stock Splits
1) No Increase in Company Value
While a stock split increases the number of shares, it does not increase the value of the company itself. The worth of the company remains the same; it is just divided among more shares.
Therefore, while individual shares may become cheaper, investors are not getting greater value. It is like cutting a pie into more slices-the amount of pie remains the same.
2) Higher Price Volatility
With a split, the stock will usually have bigger variations between ups and downs in value. The cheaper the shares are, the more buyers and sellers are drawn to them, leading to bigger changes in price.
This variability can be a bit problematic for investors, and particularly inexperienced ones, because it raises the possibilities of witnessing extreme increases or decreases in the stock’s price.
3) Could Signal Financial Issues
At times, even a split of stock may create an impression that the company is undergoing bad times.
Investors may think that the particular company splits its stock out of concern for its future or as a way of making its stock more attractive to buy.
Such an impression may further blur the financial health of the company and lead investor confidence even lower.
Conclusion
Thus, stock splits have both pros and cons. On the positive side, they increase liquidity, make shares more affordable, attract new investors, and may boost the company’s market cap over time.
On the negative side, they don’t add real value to the company, it just makes the stock more volatile, and sometimes give a negative signal about the company’s financial health.