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What is Stock Split?

Created on 23 May 2019

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Updated on 16 Oct 2020

The stock split refers to dividing one share into two or more number of shares. The stock split results in an increased number of shares of the company. Stock split results in dilution of the number of shares, but the market capitalization of the company remains the same before and after the dilution. Imagine if you have a 100 rupee note and you are given two 50 rupee notes instead of one hundred rupee note, then, it is as good as a stock split. 

Stock split results in a reduction in the price of the stock. The stock split helps in bringing in more liquidity of shares in the stock market. Whenever a company has been doing well and growing for years, the stock split happens in due course. The only purpose of splitting the stocks is to reduce their price to make them more affordable. It does not make anyone richer than earlier. 

You would find public limited companies going for stock split often as these companies keep growing bigger due to the acquisition or new product launches. So eventually, they have to split their shares to make them affordable and generate liquidity. Another famous example of a stock split is that of Berkshire Hathaway which is owned by Warren Buffet. The cost of one share of Berkshire in 1960s were just 8$ which traded between the price value of $186,900 and $227,450. The current price of Berkshire’s share is beyond the reach of most people across the world. Hence, to overcome this Warren Buffet introduced another class of shares called class B and he maintained the original shares as Class A.

Usually, the stock splits are done in the 2-for-1 split. Though, 3-for-1 split, a 2-for-3 split, and 10-for-1 stock split can also be followed at times. 

Is the stock split beneficial?

In one way, stock split suggests that the market value of the company’s shares is increasing day by day indicating positive growth in the company. But, on the other hand, the fundamental value of the stock remains the same, indicating no advantage to the investors.

The board of directors of a company comes together to decide upon splitting up the stocks. The board of directors also zero down on the number of shares of stock a firm would distribute to the existing shareholders. It’s all about slicing the pie to make thinner pieces but, the size of the pie remains the same. A stock split is usually initiated when the company fears that it will vanish out of the radar of serious stock investors.

Example: Yes Bank on September 1st, 2017 announced stock split and the outcome of it was that the share prices got reduced by 80%. The split ratio opted by Yes bank was 5 for 1. This was an example of a forward stock split and let’s see what it means in detail.

Types of stock splits

There are two types of stock splits, which are:

  1. Forward stock splits

  2. Reverse stock splits

 

  1. Forward stock splits: Forward stock splits often refer to the split in which the number of stocks increases post-split. So, the shareholders hold more number of stocks post-split than before split.

  2. Reverse stock splits: A reverse stock split is the opposite of the stock split. It aims at merging and reducing the number of shares to increase the face value of each share. A reverse stock split is alternatively referred to as stock merge, share rollback and, or, and, or share rollback. Generally, reverse stock split is followed by companies whose share prices have depleted to a great extent, and they want to bring the face value of each share back to normal. 

A reverse stock split is done when the company doesn’t want to get delisted from a stock exchange, or, to get rid of the negative impression of the stock which might be labelled as penny stock due to its abnormally low price value. A company’s stock split never changes its market capitalization, which remains the same before and after the split. 

Most financial analysts believe that splits do not always substantiate financial theory. Stock splits are usually a part of a relatively new area of financial studies which is behavioural science. There are many publications which are purely dedicated to understanding stock splits. You should never let the stock split influence your decision of buying a stock. The stocks should be bought irrespective of whether the stock splits happen or not.

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Koushik Mohan has completed MBA from National institute of securities markets (SEBI), with 1.6years of experience working with Northern Trust and CA firm in the departments like OTC derivatives and Accounting.

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