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A stock split is a corporate action which splits the existing shares of a particular face value into smaller denominations so that the number of shares increase, however, the market capitalization or the value of shares held by the investors post split remains the same as that before the split. For e.g. If a company has issued 1,00,00,000 shares with a face value of Rs. 10 and the current market price being Rs. 100, a 2-for-1 stock split would reduce the face value of the shares to 5 and increase the number of the company’s outstanding shares to 2,00,00,000, (1,00,00,000*(10/5)). Consequently, the share price would also halve to Rs. 50 so that the market capitalization or the value shares held by an investor remains unchanged. It is the same thing as exchanging a Rs. 100 note for two Rs. 50 notes; the value remains the same . Let us see the impact of this on the share holder: - Let's say company ABC is trading at Rs. 40 and has 100 million shares issued, which gives it a market capitalization of Rs. 4000 million (Rs. 40 x 100 million shares). An investor holds 400 shares of the company valued at Rs. 16,000. The company then decides to implement a 4-for-1 stock split (i.e. a shareholder holding 1 share, will now hold 4 shares). For each share shareholders currently own, they receive three additional shares. The investor will therefore hold 1600 shares. So the investor gains 3 additional shares for 59 each share held. But this does not impact the value of the shares held by the investor since post split, the price of the stock is also split by 25% (1/4th), from Rs. 40 to Rs.10, therefore the investor continues to hold Rs. 16,000 worth of shares. Notice that the market capitalization stays the same - it has increased the amount of stocks outstanding to 400 million while simultaneously reducing the stock price by 25% to Rs. 10 for a capitalization of Rs. 4000 million. The true value of the company hasn't changed. An easy way to determine the new stock price is to divide the previous stock price by the split ratio. In the case of our example, divide Rs. 40 by 4 and we get the new trading price of Rs. 10. If a stock were to split 3-for-2, we'd do the same thing: 40/(3/2) = 40/1.5 = Rs. 26.60. Pre-Split Post-Split 2-for-1 Split No. of shares 100 mill. 200 mill. Share Price Rs. 40 Rs. 20 Market Cap. Rs. 4000 mill. Rs. 4000 mill. 4-for-1 No. of shares 100 mill. 400 mill. Share Price Rs. 40 Rs. 10 Market Cap. Rs. 4000 mill. Rs. 4000 mill.
When a company is planning a stock split. Berkshire Hathaway. even if he believes that the company is a fundamentally good investment. If one share of XYZ stock is valued at $500 USD. and have never had one. since more investors are able to afford the share and the total outstanding shares of the company have also increased in the market. A company's market capitalization is equal to the number of existing shares. or small investors may feel it is unaffordable. the price of one share is also cut in half. so there is a net zero effect on total value. the investment will look much more attractive to individuals. multiplied by the share price.Why do companies announce Stock Split? A stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector. and the company's fundamentals are the same. A stock split can also result in a stock price increase following the decrease immediately after the split. there are mainly two important reasons. in some cases. an individual investor would have to pay $5. the action must be approved by the company's board of directors. 40 pre-split. thereby possibly creating greater demand for the stock. what motivates a company to split its stock? Though there are no theoretical reasons in financial literature to indicate the need for a stock split. generally. some investors may feel the price is too high for them to buy. this fact alone will increase the market value of the stock.000 USD for 100 shares. Splitting the stock brings the share price down to a more "attractive" level. the actual split as such does not affect the market capitalization or value of the company. they end up boosting demand and drive up prices. whose funds are limited. In our earlier example to buy 1 share of company ABC you need Rs. is a publicly traded company whose class A shares have at times sold for well over $100. and may keep him from purchasing the stock. Since many small investors think the stock is now more affordable and buy the stock. as well as its major shareholders. lift demand and prices. for example. that a company is implicitly confident in its economic future. but after the stock split the same number of shares can be bought for Rs.10. On the other hand.000 USD. Splitting a stock may lead to increase in the stock's liquidity. Some companies avoid stock splits as a rule. Another reason for the price increase is that a stock split provides a signal to the market that the company's share price has been increasing and people assume this growth will continue in the future. This leads us to the second reason. if it is to occur. As the price of a security gets higher and higher. and increasing its price. A stock split can signal. This will likely be a significant portion of one investor's portfolio. The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company has not changed. if one share of XYZ is priced at $25 USD. making it attractive for more investors to buy the share. If the value of the stock doesn't change. One common reason to initiate a stock split is to make a firm's stock more accessible to smaller investors. This high share price has reduced the liquidity of the . Although a company may choose to split its stock when its price is rising. and again. If this is generally perceived to be the case. When the number of shares doubles.
and of course.stock. What's the Point of a Stock Split? So. Another reason. and arguably a more logical one. The effect here is purely psychological. when . as well as having achieved its intended effect. or small investors may feel it is unaffordable. This procedure is typically used by companies with low share prices that would like to increase these prices to either gain more respectability in the market or to prevent the company from being delisted (many stock exchanges will delist stocks if they fall below a certain price per share). in a reverse 5-for-1 split. Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before. what motivates a company to split its stock? Good question. The actual value of the stock doesn't change one bit. The first reason is psychology. if the prices rises. namely that of attracting long-term investors rather than short-term speculators. 10 million outstanding shares at 50 cents each would now become two million shares outstanding at $2. For example. some investors may feel the price is too high for them to buy. they have more stock to trade. which increases with the stock's number of outstanding shares. There are several reasons companies consider carrying out this corporate action. but the lower stock price may affect the way the stock is perceived and therefore entice new investors. You see. Reverse Stock split Another version of a stock split is the reverse split. if the value of the stock doesn't change. As the price of a stock gets higher and higher. for splitting a stock is to increase a stock's liquidity. Splitting the stock brings the share price down to a more "attractive" level. In both cases. the company is worth $50 million.50 per share.
Splits are a good demonstration of how the actions of companies and the behaviors of investors do not always fall into line with financial theory. This very fact has opened up a wide and relatively new area of financial study called behavioral finance (see Taking A Chance On Behavorial Finance.000 shares for that flat rate. which has never had a stock split. It was advantageous only because it saved you money on commissions.stocks get into the hundreds of dollars per share. A stock split should not be the deciding factor that entices you into buying a stock.000 or 5. This may be true. you have the same amount in the bank. . he or she will likely tell you that splits are totally irrelevant .yet companies still do it. whether you have two $50 bills or one $100 bill. thereby increasing liquidity. but on the other hand. The flat rate therefore covers most trades. signaling that the company's share price is increasing and therefore doing very well.000 shares. Some online brokers have a limit of 2.). There are entire publications devoted to tracking stocks that split and attempting to profit from the bullish nature of the splits. None of these reasons or potential effects that we've mentioned agree with financial theory.). buying before the split was a good strategy because of commissions that were weighted by the number of shares you bought. Advantages for Investors There are plenty of arguments over whether a stock split is an advantage or disadvantage to investors.000 and its bid/ask spread can often be over $1. Critics would say that this strategy is by no means a time-tested one and questionably successful at best. Berkshire stock has traded at nearly $100. While there are some psychological reasons why companies will split their stock. If you ask a finance professor. This isn't such an advantage today because most brokers offer a flat fee for commissions. Factoring in Commissions Historically. but most investors don't buy that many shares at once. however. At times. A perfect example is Warren Buffett's Berkshire Hathaway. very large bid/ask spreads can result (see Why the Bid/Ask Spread Is So Important. One side says a stock split is a good buying indicator. the split doesn't change any of the business fundamentals. so it does not matter if you buy pre-split or post-split. you can't get around the fact that a stock split has no affect on the fundamental value of the stock and therefore poses no real advantage to investors. Conclusion The most important thing to know about stock splits is that there is no effect on the worth (as measured by market capitalization) of the company. In the end.000. Despite this fact the investment newsletter business has taken note of the often positive sentiment surrounding a stock split. so you pay the same amount whether you buy 10 shares or 1. By splitting shares a lower bid/ask spread is often achieved.