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Why companies do not prefer stock splits?

Created on 28 Dec 2020

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Updated on 10 Sep 2022

stock splits

Imagine this - You are looking to invest some money in the share market. You check the current market price of a share of MRF, and it is somewhere around Rs. 75,882. You think this is expensive. Then, you look at the share price of Wipro, and it is Rs. 385. Now, this looks affordable, right?

Do you think the share price of MRF is higher because it is better than Wipro? How do you decide which company you want to invest in? Have you ever wondered why there is a massive difference in the share prices of companies?

The reason why shares of MRF trade at such exorbitant prices is because the MRF management hasn't split its shares. Similarly, Wipro shares trade at lower prices because they've been split multiple times.

So, what exactly is the splitting of shares, and why wouldn't the companies split their shares? Let's find out.

What do you mean by stock split?

Let us try to understand this with a delicious example. Say you have a pizza. How do you split it? Into four pieces? Into eight pieces? You see, no matter how many pieces you cut, the overall pizza remains the same.

Now, let's put this from a company's perspective. A company splits its shares into different shares under stock splits. For example, in the case of a 1:1 stock split, one share is split into two parts. In case of a 1:5 stock split, one share splits into five parts. The essential point here is that the number of shares increases in stock splits, but the overall share capital remains unaltered.

If there is no change in overall capital, why do companies split stocks?

Indeed, a company's overall share capital does not change after a stock split, but there are reasons why a company might still choose to do it. The reasons can be:

  • Splitting stocks makes the share prices affordable to buy for retail and small investors. Suppose a company's stock trades for Rs. 2,000. It announces a split of 1:10. Now one share will trade at Rs. 200. Naturally, investors would prefer to purchase the shares at Rs. 200 then Rs. 2,000.
  • Companies can increase their liquidity through stock splits because it causes an increase in the trading volume of their stock.
  • Companies also prefer to opt for a stock split when they want their stock to be concentrated with a smaller number of shareholders.
  • Stock splitting helps companies to build a diversified investor base for their stock.

How does a stock split affect shareholder wealth?

There is not much effect on the personal wealth of shareholders either. A holding of one stock of Rs. 10,000 would be the same as a holding of 5 stocks of Rs. 2,000 each for the existing shareholder.

So, what's the catch?

Let's not stay under the notion that stock splits do have any effect whatsoever. Whenever stocks are split, there are many shares in the market to trade, so share prices come down. Another thing that is impacted is the earnings per share (EPS) of the company. Since profit is divided by the increased number of shares, the EPS also decreases accordingly. It is to be noted that the price-earnings multiple remains the same since both the share price and EPS decrease.

Why do some companies don't split their stocks?

We have discussed the benefits and driving reasons that encourage companies to split their stocks. However, some companies still prefer not to split their stocks. Following are the possible reasons:

The stock has done good so far. Why bother splitting it now?

In the beginning, we saw that a share of MRF sold for Rs. 75,882. In 2010, it traded at around Rs. 8,786. Sure, the stock was as expensive back in 2010 as it is now, but it has returned 763% to its shareholders. This raises a potent question that if the company is doing good and giving healthy returns to its shareholder despite high prices, why should it bother splitting its stock?

Concentrated shareholding and power

When the share prices are high, the shares are bought by fewer investors with that amount of money to spend. This leads to the stock getting concentrated in the hands of a few shareholders. Higher priced shares are not easy to sell either. So, this helps in checking the price volatility of shares.

When a company allows its shares to be traded at a higher price, the promoters can retain significant voting rights in their hands, allowing them to make critical decisions without external interference.

Security against hostile takeovers

As we've already seen, higher share prices lead to stocks being concentrated in the hands of a few shareholders. This phenomenon also helps to avoid scenarios of creeping acquisitions or hostile takeovers. High share prices are often discouraging factors of acquisitions.

If there are no financial benefits per se, why bother with stock splits?

Stock splits do not alter the financial fundamentals of a company. The ratios don't change, and the value of share capital also remains the same. So, unless the company has a compelling reason, it shies away from stock splits.

Avoid day-trading

Companies usually prefer not to split their stocks because that would lower their share prices. This would make their stock attractive to retail and small investors, leading to day-trading and breeding liquidity.

This increased trading would also open the prices to volatility. Lower prices also attract speculators and casual traders, and the companies usually try to avoid that from happening.

The charade of prestige

This is more of psychological thought, but many companies do believe higher share prices give them a level of prestige. A stock price of Rs. 10,000 would be perceived as more valuable even though its market capitalization would be the same as that of a company whose shares trade at Rs. 100.

Closing thoughts – Are stock splits necessary?

We have discussed why a company may split its stock. We have discussed why a company may not split its stock. The arguments for both these scenarios make sense to some extent. And there is no hard evidence that supports either notion. There are no regulatory guidelines for stock splits either.

Moreover, high prices of shares are not a limiting factor for investors with the introduction of the concept of fractional shares. Investors can now hold blue-chip stocks with limited capital too. So, nowadays, it is a company's call whether or not it wants to split its stock because investors have avenues to access their stocks even though they're trading at high prices.

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