What is the purpose of companies declaring stock splits? How does a stock split affect shareholders if there is no change in market price?

 

     A stock split is a corporate action where a company divides its existing shares into multiple new shares, thereby increasing the number of shares outstanding. Despite this increase, the total value of the shares and the company’s market capitalization remain unchanged because the price of each share is adjusted down proportionately. Stock splits are often viewed as symbolic moves that signify a company’s confidence in its growth, but they can also have practical implications for investors and the market.

 

    For example, in a 2-for-1 stock split, each existing share is split into two, effectively doubling the number of shares outstanding, while the price of each share is halved. If a stock was trading at Rs.100 before the split, it would trade at Rs.50 afterward. This action does not affect the intrinsic value of the company or the value of a shareholder’s holdings, but it does influence market dynamics in various ways. Understanding why companies declare stock splits and the effects they have on shareholders can help investors navigate their stock investments more strategically.

 

Purpose of stock splits

 

1. Enhancing liquidity

 

     One of the primary reasons companies opt for a stock split is to increase the liquidity of their stock. Liquidity refers to how easily shares can be bought or sold without significantly affecting the stock price. When a stock price rises substantially, trading volumes may decline because the higher price becomes unaffordable for smaller investors, particularly retail investors. By lowering the price per share, a stock split makes the stock more affordable for a wider range of investors, which can lead to an increase in trading activity and improve liquidity.

 

    Increased liquidity can be beneficial for both the company and its investors. For the company, higher liquidity may result in more stable pricing and a better reflection of the stock's true value. For investors, higher liquidity often means lower transaction costs (tighter bid-ask spreads) and easier execution of trades, reducing the likelihood of price slippage.

 

2. Psychological appeal and affordability

 

     While stock splits do not change the intrinsic value of a company, they can have a psychological impact on investors. Stocks with a high price per share, especially those above Rs.1,000, can feel unaffordable to smaller investors who may be discouraged from buying even one share. By lowering the price per share through a stock split, companies make their stocks seem more affordable and accessible, even though the overall value of the investment remains unchanged.

 

    For example, a retail investor may be hesitant to buy a single share of a stock priced at Rs.2,000 but may feel more comfortable buying five shares at Rs.400 each after a split. This perception of affordability can lead to increased demand, as investors feel they are getting more "bang for their buck," even if their overall ownership in the company has not changed. This increased demand can sometimes lead to upward pressure on the stock price post-split, despite no fundamental changes in the company’s business.

 

3. Expanding investor base

 

    Stock splits can help companies attract a broader range of investors, particularly retail investors. Some institutional investors or mutual funds also have guidelines or restrictions that limit their ability to purchase shares of companies with high stock prices. By reducing the price per share through a split, companies open the door for a wider range of investors to participate in their stock, increasing demand.

 

   Additionally, certain brokerage platforms allow fractional share purchases, but many investors still prefer to buy whole shares. A split, therefore, allows more investors to own a larger number of shares at a reduced price, making the stock more appealing to those who prioritize owning a significant quantity of shares over the total dollar amount of their investment.

 

4. Signaling strong performance

 

     Stock splits often occur after a company’s share price has risen substantially over time, which can be seen as a positive signal. Companies usually declare stock splits when they are performing well and their share prices have risen to levels that could deter smaller investors. A split can thus indicate that management expects continued growth and confidence in the company's future prospects.

 

    While stock splits do not directly improve a company’s financial health, the announcement of a split is often viewed positively by the market. Investors may interpret the split as a signal that the company’s stock is doing well and could continue to appreciate in the future, which can lead to a temporary boost in the stock’s price after the split is announced or executed.

 

5. Increasing market participation

 

    By lowering the per-share price, stock splits increase market participation by making shares more accessible. When more investors are able to participate in buying the stock, it can lead to more active trading, increased visibility of the company’s stock, and greater alignment between the stock’s price and its perceived value in the marketplace. This democratization of share ownership is another reason why companies may choose to execute stock splits.

 

Impact of stock splits on shareholders

 

1. No immediate change in value

 

      For shareholders, a stock split does not result in an immediate increase or decrease in the overall value of their investment. If a shareholder owns 100 shares of a company priced at Rs.200 per share, the total investment is worth Rs.20,000. After a 2-for-1 split, the shareholder will own 200 shares, but the price of each share will drop to Rs.100. The total value of the investment remains the same at Rs.20,000.

 

    Despite this neutrality in terms of value, stock splits often lead to increased liquidity and potentially more demand for the stock, which can lead to price appreciation over time.

 

2. Increased liquidity and trading volume

 

     One of the most tangible benefits of a stock split is the increase in liquidity, as it makes shares more affordable and appealing to a broader group of investors. Higher liquidity can result in increased trading volume, which, in turn, may lead to more efficient pricing. This increased activity can also reduce price volatility and enable investors to buy and sell shares more easily.

 

    For investors looking to exit their positions or rebalance their portfolios, higher liquidity makes the process smoother. It’s also beneficial for traders, as more frequent trading leads to better price discovery, reducing the chance of getting unfavorable prices due to low trading volume.

 

3. Potential for future price appreciation

    Although stock splits do not inherently increase a company’s value, they can lead to price appreciation in the long term due to increased demand and liquidity. Historical data shows that stocks often see price gains in the months following a split, largely due to increased interest from new investors and the psychological factors discussed earlier.

 

    However, this is not guaranteed, and investors should not rely on stock splits alone as a reason to buy a stock. The company’s underlying fundamentals, such as revenue, profit margins, and growth potential, should always be the primary factors in making an investment decision.

 

4. No immediate impact on dividends

 

    For dividend-paying companies, stock splits do not immediately affect the total amount of dividends an investor receives. After a split, the dividend per share will be adjusted downward in proportion to the number of new shares issued. For example, if a company pays Rs.4 per share in dividends and undergoes a 2-for-1 split, the dividend per share might be reduced to Rs.2, but because shareholders now own twice as many shares, the total dividend income remains unchanged.

 

    In the long term, if the company continues to grow and its stock price appreciates, it may raise its dividends, but this is not a direct result of the stock split itself.

 

5. Impact on stock options

 

     Investors holding stock options will also see adjustments to the terms of their contracts following a stock split. The strike price of the options will be reduced, and the number of shares covered by each contract will increase in proportion to the split. These adjustments ensure that options holders are not unfairly advantaged or disadvantaged by the split. Investors need to be aware of these changes to understand how their options positions might be affected.

 

Conclusion

 

    In conclusion, stock splits are a valuable tool that companies use to enhance liquidity, improve the affordability of their shares, and signal strong growth potential. Although a stock split does not directly alter the value of a company or its shares, it can have significant secondary effects. For shareholders, stock splits often increase liquidity, make stocks more accessible, and can even lead to long-term price appreciation.

 

While stock splits should not be viewed as a fundamental reason to buy a stock, they are often associated with periods of strong performance and growth, making them a noteworthy event for investors to monitor. Understanding the mechanics and implications of stock splits can help investors make more informed decisions about their investments.