Through this post you’ll come to know, What is a Stock Split? Its meaning, reasons why companies have a stock split and some perfect real examples explaining this interesting stock market concept.
Usually, markets are the hub for primary movements in the economy. As a resultant, markets have also become a huge source of employment and earning, but as more and more people with different minds get involved, different techniques evolve over time. Stock split, is one of those stock market techniques. So, let’s firstly understand the basics of a Stock Split and then get into its details.
What is a Stock Split?
A stock split is the procedure of splitting the value of shares, keeping the market capitalization intact but changes the number of shares.
Think of it this way. Stock splits are like when you get smaller denominations from a big, say 2000 rupee note. It basically has the same logic. See, why you get that done is because first you don’t expect everyone who trades with you to have denominations and you don’t want that to be a hindrance.
For example, you take a cab somewhere and even though the driver’s literal job is to drive people around and collect money, he doesn’t have denominations to give the change back. You see, stock splits work on the same problem! We’ll get into whys of stock split, let’s first understand the how.
You may also like to explore: Different Types of Stocks Every Investor Should Know
Stock Split Example:
For instance, say you had 10 shares of Scarface ltd. worth Rs. 100 each, making your total holding in Scarface Ltd. worth Rs. 1000. Now the company’s CEO, Tony Montana announces a 2-for-1 stock split. This basically means that each share is now worth half its value, because now each share is 2 shares instead. Because they said so. So, now your 10 shares become 20 shares worth Rs. 50 each.
Simple enough, right?
How Does Stock Split Impact Your Portfolio?
Now if you’re like me, you might be wondering how it happens. Does the share magically break into denominations of the split in your account? Kind of. See the way it happens if the share that you hold decreases to the amount post-split and new shares are added in your account, by the company.
But having said that, it does not have any major impact on your portfolio in the short term. Your portfolio is just made whole, which means no profit or loss from the split itself. This means if you had 10 shares of Scarface Ltd. before, you will now simply have 20 shares keeping your total investment intact at Rs. 1000.
With that said, companies usually prefer to do a stock split when the price of the shares is increasingly high. But, there are several more factors to it.
Why do Companies have Stock Splits? Reasons
Well there is not a single answer to that, but multiple interlinked answers, most of which on the single logic of the price of the share being very high.
The first is to increase liquidity for the share. Let’s go back to the cab example. See, basically by having the same total assets, i.e. Rs. 2000 but in smaller denominations, what you have basically done is increase liquidity for your cash.
Now this also points to the general psyche of investors. On most of the days, the volume traded of high priced shares, like MRF, which trades around Rs. 50000, is usually lower than their similar industry lower priced shares, say Apollo Tyres, which trades around R.s 150 a share.
One of the reasons companies also mention are things like protecting the interest of minority individual shareholders. The rationale is that individual investors don’t usually invest in highly priced shares, because in terms of risk, high priced shares have major liquidity concerns. Moreover, while referring to individual investors as a class, it is possible that they don’t have huge amounts of money to invest, again decreasing the general market interest of shareholders.
Now while aforementioned reasons are true, they aren’t the causal factors. They are more like ‘Oh and this is also a benefit for with this’ kind of reasoning. Now, let’s get into why it is always in the interest of management to do a stock split, more than any other investor.
What Does a Company’s Management Gain Out of Stock Split?
The above reasons are the most common reasons given. They are true, no doubt. Management do gain with the excess liquidity of shares. But there is one more reason why it always benefits the management in the long run.
You see, as you move up in hierarchy in any organization, majority of your compensation, increasingly, comes in shares. Now when share prices of the company are touching record highs, it is good, but only for traders and investors, not the management because in the long run, it decreases volume traded, decreasing the incremental growth. You see because high share price slowly decreases the demand of shares because not everyone can afford the price, it decreases the volume in turn, which is the first major reason of increase in share price. This can be detrimental to growth in the long run for both long-term investors and management, both of whom hold shares keeping the long game in mind.
So, while in theory stock split doesn’t increase market capitalization, it does do that in the long run. This is how it happens. A company issues a stock split increasing liquidity of the share. This in turn increases the volume traded of the share. This, in turn, disrupts the demand-supply chain of the shares. Now because there is an increased demand for the share, the price increases. This, combined with other factors, happens till the share price eventually reaches the pre-split price, or three quarters of that. But, this also means market capitalization of the shares increases, primarily due to split, since market cap is nothing but number of total outstanding shares multiplied by share price.
This primarily benefits the long-term shareholders of the company, which in most cases are the company’s management.
Benefits from Stock Split: Examples of Companies
Apple and Walmart are the most famous ones, both company’s management very well known to protect its shareholder’s interest.
In fact, in the current scenario Apple is the most recent and interesting example to quote here. Apple has went through stock split four times, since 1987, when the price of the share was around $50. Most recently, Apple went through a 7-for-1 stock split in 2014, when the shares crossed $2000. As on July 25, 2020, the share price was around $370. Also, did you read about Apple’s 4-for-1 stock split announcement? This is the company’s fifth stock split since it had gone public. The price jumped to $500 per share in August making it an ever more attractive company for retail investors.
Excited!! Know how stock split increases market capitalization in the long run yet.
In the Indian markets, Eicher Motors has announced a 10-for-1 stock split, about in May 2020. Since then, the share price has rallied up by 49%. So yes, sometimes the news of stock split can be as effective as the stock split itself. Eicher Motors is primarily known for its motorcycle brand, Royal Enfield.
The Bottom Line
With stocks rallying just at the news of split, it may give signals for a lot of things. Mostly, it is a positive sign for the Board of Directors and investors alike, because it usually shows how aware a company is about its position in the market. However, nothing can be certain, right?
And, that was all about Stock Split and related information. Do you wish to discuss anything important regarding stock splits or any important stock market concept, do drop in the comment section.