A company decides to share split or reverse stock split when its share prices are either too high or too low. A share split lowers the price of an individual share of a corporation by dividing each existing share into many shares. A lower share price is naturally more attractive, through which a company expands its investor base. As the new share price correlates to the new number of shares, it does not change the value of the shareholder’s stock and the company’s market capitalization

In contrast, a reverse stock split raises the share price and ensures a company’s listing on the stock market.

This article covers:

What is stock split?

Stock split takes place when a company splits one share of its stock into more shares. When a stock is split, the shareholder gets two shares of the same value, that are equally divided in face value. 

Depending upon the company, the split in stock generally takes the form of: 

  • 2 for 1 or 
  • 3 for 1 or 
  • 5 for 1

With a share split, a company issues more shares of its stock to its current shareholders without reducing the value of its stakes. Therefore, a stock split increases the number of outstanding shares and lowers the individual value of each share. 

While the number of outstanding shares changes, the overall company’s valuation as also the value of each shareholder’s stake remains the same.

For instance, ABC company takes one share and announces a 2-for-1 stock split—each share is then split into two shares. Now, if the original share price was Rs. 20 for one share, the new shares would each be priced at Rs. 10.

The total combined value of the two new shares is still equivalent to the price of the previous one share. Thus, stock split does not affect market capitalization or the total value of shares held.

What is a reverse stock split?

In case of a reverse stock split, you get fewer shares than you previously had and at a higher per-share price. When a company realizes that its per-share price is depressing or is dropping so low that the stock might even get delisted on the exchange, then in such a scenario, it may carry out a reverse stock split. 

For example, consider Mr X owns 1000 shares of ABC Ltd at Rs. 200 per share. Now if a reverse stock split is announced of a ratio 5-1, then Mr X would become the owner of 200 shares at a revised Rs. 1,000. Note that the total corpus owed, i.e., Rs. 2 lakh has remained the same post-split as well.

Types of stock split

The most common stock splits are further categorized as: 

2-for-1: In a 2-for-1 stock split, you as a shareholder receive two shares after the split for every share you owned before the split. 
3-for-1: In a 3-for-1 split, you receive three shares for every share. 
3-for-2:  In a 3-for-2 split, you receive three shares for every two. 

However, there are also examples of 5-for-1 or 7-for-1. 

On 31 August 2020, the electric car company—Tesla split its stock 5-for-1. Before the split, the price of a Tesla share was about $2,213. At closing on 28 August 2020,  after the split, shares were about $ 442 each.

How does stock split affect investors?

The underlying value of your investment is not affected by stock split. As a result, no substantial changes occur in your investment account other than the number of shares.

If you already have shares, there is no particular advantage in store for you as nothing about the ownership changes. If one is not a shareholder, a stock split may motivate them to buy the particular share. 

Companies that have high share price look to stock split to call in more investors and increase liquidity.

Merits of stock split

Improves liquidity

When the number of outstanding shares increases at a lower price per share, it adds liquidity. This increased liquidity further also narrows the spread between the bid and ask prices. As a result, investors get better prices when they trade.

Simplifies portfolio rebalancing

It is easier for the portfolio managers to sell shares to buy new ones when each share price is lower.

Doubles the number of shares

A 2 for 1 stock split doubles the number of shares instantly. It grants you two shares for every one share you own. Say, you have 100 shares of a company that splits its stock, you’d end up with 200 shares after the split. The value of your holding does not increase, but it makes your trading transactions easier. A 2 for 1 stock split is especially beneficial for retail investors; they can acquire a large number of blue-chip company shares which are otherwise expensive.

Increases share prices

When a stock is split it boosts share prices, this is one of the most compelling reasons for a company to take the decision in the first place. Based on a Nasdaq study, only the announcement of a stock split may increase the share price by an average of 2.5%.

Demerits of stock split

Increase volatility

The new share price could increase volatility in the market after split. More investors may come to the decision to buy the stock because of its affordability. Typically, this could increase the volatility of the stock.

Novice investors tend to believe stock splits are good because they do not differentiate between correlation and causation. 

Not all stock splits result in increased share price – in some cases, stock splits occur when a company faces the danger of its stocks being delisted — a common example of reverse stock split. Although the per-share price may increase after the reverse split, the stock may not grow in worth. Novice investors may thus stand to lose money.

Capital loss

If the investor has invested in unstable stocks that might later go for a split, it may end up eroding their entire capital.

Affects financial ratios

During a split or reverse split, if the share price happens to fall, it may badly reflect in the financial ratios of the company. Many important ratios like P/E and EPS are directly impacted by the current share price. Investors who keenly follow such numbers and ratios may then refrain from investing in such stocks.

How does stock split affect taxation?

The value of your overall holding does not change before and after the stock split. Therefore, you do not get increased liability or a reduction in your tax. 

You should, however, seek financial counsel before investing in shares as such investments are subject to market risk.

Conclusion

Companies listed on exchanges carry out the process of splitting their shares for numerous reasons. While shareholders are technically not impacted, it is still important to understand why a particular company is undergoing a stock split, what will be the major changes in face value and other ratios and so on and so forth. Neither should every split worry the investor nor should the investor take any split casually. 

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