Stock split is not a mere technical change. It is a strategic move for businesses to make their shares more popular and within reach of more investors. Even though this action does not alter the fundamental value of the company, it might impact the trading habits and ownership ratio in a significant manner. 

What is a stock split?

A stock split takes place when a company decides to divide each existing share into multiple units. This results in shareholders holding a greater number of shares while the value per share decreases in proportion. The overall worth of their investment, however, remains unchanged.

To illustrate, consider a company that declares a 2-for-1 stock split. If a shareholder owns 50 shares priced at Rs. 1,000 each before the split, they would end up with 100 shares priced at Rs. 500 each post-split. Although the number of shares has doubled, the total investment value stays at Rs. 50,000.

Why do companies initiate stock splits?

The usual course for firms is to make stock splits when the price of a share has increased to the extent that it becomes too costly for individual investors. High prices per share might restrict access by small investors, which can curtail trading. Through reducing the per-share price, the firm seeks to make its shares cheaper and more accessible, potentially causing demand and trading volume to increase.

Moreover, a stock split announcement can be a signal of management belief in the company's growth story. Although the firm’s actual valuation remains the same, the move can improve market sentiment and broaden the shareholder base.

How stock splits affect liquidity

Liquidity is a term used to describe the ease with which shares can be sold or purchased in the market without causing their price to change much. When shares sell at high prices, they can turn away more buyers, especially retail investors. A stock split lowers the share price, which tends to entice more people to invest.

Since there are more shares available in the market at a reduced price, the company's stock usually sees higher trading volumes. This rise in traffic can reduce the bid-ask spread and enhance overall market efficiency, allowing investors to more easily get in or out of positions.

What changes for shareholders?

For current shareholders, a stock split increases the number of shares they own without changing the overall value of their investment. Their stake in the company stays unchanged.

For instance, if an investor owns 10 shares valued at Rs. 2,000 each, a 5-for-1 split would result in them owning 50 shares priced at Rs. 400 each. The total holding would still amount to Rs. 20,000. Although the number of shares has increased, there is no gain or loss in investment value.

Types of stock splits

Regular (forward) stock split

The number of outstanding shares rises with a regular or forward stock split. Split ratios of 2:1, 3:1, or greater are typical. These are usually implemented when a business wants to increase liquidity and lower the price of its stock after it has become too high.

Reverse stock split

A reverse stock split, on the other hand, combines several shares into a smaller number of units at a higher price per share. Shareholders experience no change in the overall value of their holdings, as the company simply adjusts the number of shares they own. Reverse splits are often used by businesses to raise their share price, especially if it has dropped too low and risks falling below regulatory thresholds. For instance, 1,000 shares priced at Rs. 5 would become 100 shares priced at Rs. 50 in a 1-for-10 reverse split. The price per share rises while the total investment value for shareholders stays the same.

Impact on valuation and market capitalisation

It is critical to realize that a stock split has no impact on the underlying valuation of a company. The revenues, earnings, and assets of the business are unchanged. Market capitalization, share price times number of shares outstanding, is also unchanged in the immediate aftermath of the split.

Yet, a split can actually cause the share price to increase over the long term if it creates better demand and enhanced investor interest. This is especially the case when a company with sound fundamentals employs the split as a means to attract more retail investors and make itself more visible in the marketplace.

Does a stock split benefit investors?

A stock split can have indirect advantages even though it doesn't result in immediate financial gains. The split might draw in more investors by lowering the share price. After the price has been lowered, it might be simpler for retail participants in particular, to purchase or accumulate shares.

As a result of the reduced entry price, investors find it easier to diversify their portfolios. Even when the total value of the shares is the same, psychologically speaking, people are frequently more at ease purchasing several shares at lower prices than fewer shares at higher prices.

Are there any disadvantages?

Even though stock splits are generally seen favorably, there are some disadvantages. Even if there isn't a corresponding improvement in financial performance, companies sometimes use stock splits to attract attention. Expectations in the market may rise as a result.

Also, shares with lower prices are occasionally more vulnerable to short-term price swings and speculative trading. Long-term investors may find it more difficult to determine the stock's actual direction when volatility is elevated.

In particular, reverse splits could be problematic. They may be interpreted as attempts to conceal financial difficulties or keep a company's shares from dropping below necessary trading thresholds if they are employed frequently or in the absence of a clear growth strategy.

What investors should consider

You don't have to do anything if you already own stock in a company that announces a stock split. Your brokerage will automatically update the number of shares in your demat account.

Nevertheless, determining the cause of the stock split is crucial. A split that is supported by strong earnings and room for expansion is a more positive signal than one that is only intended to spark market interest.

Potential investors ought to investigate whether the division is a component of a more comprehensive business plan. Before making an investment based on a split, it can be helpful to analyse financial statements, comprehend the company's position in the market, and monitor sector performance.

Conclusion

A stock split does not change the intrinsic value of a company but can influence how the stock is perceived and traded. By increasing the number of shares and lowering their individual price, companies can improve accessibility and stimulate investor participation.

The primary advantage for investors lies in better liquidity and affordability. However, it is important to evaluate the broader financial picture before acting on a stock split. As with any investment decision, a well-informed approach is essential for achieving long-term success.