Recently, the board of directors of Eicher Motors approved a 10-for-1 stock split. Does this mean you have to forgo your shares or parts of them? Does this mean the value of your shares in Eicher Motors will slash? Does this mean your investment portfolio will carry a lower value after the stock split? But what is a stock split anyway? And why should you care? We’ll discuss that and more in this piece. Let’s dive right in.
The article covers:
Introduction to the concept of a stock split
As per Lexico, split means to “Break or cause to break forcibly into parts, especially into halves or along the grain”. Evidently, if you split a thing you own or enjoy, you will have to forgo a part of it. Does this mean you are at loss or gain?
On the face of it, a split definitely seems like a loss. Unless you did it wholeheartedly. So, does this mean a stock split is bad for you as an investor? Well, not necessarily. More often than not, a stock split can be good news.
Stock split meaning
Simply put, a stock split happens when a company divides its outstanding (issued share capital) into a higher number of shares while lowering the price of an individual share. The company decides its split ratio and increases its outstanding capital proportionately by issuing additional shares to its existing shareholders.
Stock split neither changes the value of a company’s market capitalization nor that of your investment, but decreases the value of an individual share. It is natural when you split 10 rupees into five people, though the currency will have the same value, each of the participants will only receive two rupees. Besides, a stock split also keeps your stake in a company unchanged. We shall discuss this in detail below.
Now that you are familiar with the stock split meaning, let’s see how it works.
How does a stock split work?
As mentioned, a company decides its own split ratio, which can be anything such as 2-for-1, 5-for-1, and 10-for-1. To understand how stock split works, let us see a stock split example.
Assume that XYZ company has an outstanding capital of 1 lakh shares with a face value of Rs 10. The board of directors decides to go for a 5-for-1, the ratio of the stock split. Now, for every share that has been issued, XYZ will offer 5 new shares. This way, the company will end up having 5 lakh outstanding shares after the stock split. In other words, you, as the existing shareholder of XYZ will receive 5 new shares for every 1 share that you already hold.
However, the face value of each share now decreases to Rs 2. The idea is to keep the value of every 5 shares equal to that of one share before the stock split. On the other hand, your ownership or stake in XYZ remains unaffected by a stock split. Here’s a table illustrating the same.
Why does a company undertake a stock split?
A company can undertake stock split for various reasons.
- The company’s share price increases to a level that it becomes expensive for investors to buy. So, it decides to split its stock to make it affordable and accessible to potential investors
- The company’s share price has increased more than its peers and it wants to bring it down
- The company wants to achieve liquidity based on human psychology. It is more likely that investors would buy affordable shares in large quantity than the expensive ones in small quantity. For instance, we would prefer buying more of something (100 shares) at a price (Rs 10 each) than purchasing less (10 shares) of it at a higher price (Rs 100 each). Notice that the value you get is same in both the cases but it is what it is: affordable shares are perceived to be more liquid and less risky
- The company wants to give out a positive sign to investors by indicating that it is growing
- A stock split makes shares more affordable and hence increases the demand for the company’s shares among investors. This, in turn, can increase the stock price after shares are split. In simple words, the law of demand and supply plays out here
Stock split example
While there are many examples of stocks split, here’s one of Apple, the well-known multinational technology company. In 2014, Apple split its stock in the ratio of 7-for-1, which slashed the stock price from ~$650 to $90 in the matter of a day.
How can stock split impact your portfolio?
A stock split has chances of doing good than harm to your investment portfolio. Here’s how you as an investor will be affected by a stock split.
Stock split adds additional shares to your portfolio
Since a stock split demands a company to increase its outstanding shares, your shareholding in the company increases in terms of the number of shares. However, the percentage of your holding in the share capital remains unchanged.
Stock split doesn’t increase the value of your investment
As mentioned, stock split only increases the number of shares that you hold in a company. Though you own more shares now, the value per share decreases proportionately. Ergo, a stock split doesn’t inflate the value of your investment.
Investment value increases if share prices rise after a stock split
If after the stock split, the demand for the company’s share increases, the price per share would appreciate. As a result, the value of your investment/portfolio in the company would also increase.
Who can benefit from a stock split?
Stock split benefits the company, existing shareholders, and potential investors. A lower post-split value per share opens doors to potential investors looking to invest in the company. The company, in turn, enjoys greater liquidity. Besides, the existing shareholders as on or before a date specified by the company, also get to hold a higher number of shares.
Reverse stock split
A company can also split stocks in a reverse manner. Meaning, the company decreases its outstanding shares while increasing the price of an individual share. The likely reasons for undertaking a reverse stock split can be as follows:
- The company wants to meet the minimum level of share price required to get listed on a stock exchange
- The company runs a risk of being delisted from stock exchange because its price per share has fallen below the required limit
- The company wants to inflate its share prices and thus build up its image in the stock market
So, more often than not, there’s no reason to panic should a company in which you hold shares announces a stock split. Investigate the reason before drawing a conclusion or liquidating your position.
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