What is Stock Split - Uses, Working, Types and Pros and Cons (2024)

To broaden its investor base, a company may execute a stock split. This corporate action is typically implemented when a company's share price becomes prohibitively expensive for potential investors. A stock split increases the number of shares outstanding without altering the company's overall value, aiming to make shares more affordable and accessible.

What is a stock split?

A stock split is a corporate action whereby a company increases its outstanding shares to enhance liquidity. Common split ratios are 2-for-1 and 3-for-1 (or 2:1 and 3:1). In these scenarios, shareholders receive two or three new shares, respectively, for each share previously held.

Another important aspect to remember is that while the stock split reduces the share price, it does not impact its current shareholders. This is because the organisation lowers the face value of each share at a certain ratio. By dividing the shares previously issued to the existing shareholders, the number of outstanding shares is increased, but the value of each shareholder’s stake doesn’t change.

The stock split is done in a prescribed ratio. Let us assume that this ratio is 10:1 (or 10-for-1). The 10:1 stock split meaning is fairly intuitive; it implies that for every one share held, shareholders get ten shares (post-split). To better understand this concept, let us look at the table below that highlights the number of shares, split share prices, and the face value of the share pre and post-split for various ratios.

As evident from the table, the investment value does not change. You must also remember that in a stock split, the share’s face value is reduced by the ratio of the split.

What happens when a stock splits?

A stock split simply divides the existing shares of a company into multiple new shares. Owing to this split, the number of shares increases, and the stock becomes more affordable. It must be noted that the total value of the shares remains the same because the split doesn't add any real value.

All the existing shareholders get an equal number of shares to their present holding. Now, they will hold more shares at a lower price per share. Typically, stocks are split in the ratios of 2:1, 3:1, and 5:1 (this can vary). This implies that the existing shareholders will have 2, 3, or 5 shares for every share they hold.

Stock Splits - Why companies use itand itworks?

A stock split is a corporate action wherein a company divides its existing shares into multiple new shares. While this operation does not alter the company's overall market capitalization, it significantly impacts the share price and number of outstanding shares. Companies often undertake stock splits to enhance their stock's liquidity and accessibility. A high share price can deter potential investors due to the substantial investment required for acquiring a single share. By dividing the shares, the company effectively lowers the price per share, making it more affordable for a broader investor base. This increased accessibility can lead to higher trading volumes and improved liquidity.

Furthermore, a stock split can be a strategic move to enhance the company's image. A lower share price can create a perception of affordability and growth potential, attracting new investors. This can positively influence market sentiment and potentially drive up the stock price in the long term.

Mechanics of a stock split

In a stock split, the number of shares increases proportionally, while the share price decreases correspondingly. For instance, in a 2-for-1 split, each shareholder receives two new shares for every one share held previously. The total investment value remains unchanged.

For example, if an investor owns 100 shares of Company XYZ at ₹800 per share, the total investment value is Rs. 80,000. Following a 2-for-1 stock split, the investor would hold 200 shares at ₹400 per share, with the total investment value staying at Rs. 80,000.

It is essential to note that a stock split does not inherently create additional value for shareholders. The underlying fundamentals of the company remain unaffected. The primary benefits of a stock split are often psychological and related to improving market liquidity and accessibility.

Types of stock splits

1. Regular stock split

In this method, a company issues additional shares to current shareholders. This increases the number of outstanding shares, which leads to a fall in the normal price. Investors must note that the company’s valuation and market capitalisation remain constant.

1. Reverse stock split

As the name suggests, this method is the opposite of the regular stock split. Instead of issuing new shares, a company absorbs the excess shareholding following a pre-defined ratio. For example,

• Say you hold 10 shares of a company at Rs. 10 per share.
• The company declares a “2-for-1 reverse stock split”.
• Now, you would end up with 5 shares.
• However, the overall value of your shares remains unchanged.
• Earlier, you had 10 shares worth Rs. 4 each, making the total investment Rs. 40.
• After the reverse split, your total investment value stays at Rs. 40. However, the 5 shares would be worth Rs. 8 each.
• Overall, the number of shares is reduced. Your value of holding remains the same.

How does a stock split affect you?

Existing shareholders may not observe any perceptible changes or effects following a stock split. However, this can ease your portfolio management and offer more liquidity, along with more number of shares. On the other hand, if you are a prospective shareholder looking to invest in the company, you can purchase shares at a lower price following the stock split.

You may still wonder why a company would split shares, but there are several reasons why companies choose to subdivide their shares. The main reason is to increase the stock’s liquidity, which increases with its number of outstanding shares. Another reason is more psychological; a stock with a high share price can act as a deterrent. By splitting the stock, the company can reduce the share price to make it more appealing.

Let us take an example. Assume that Apollo Hospital’s share price pre-split was Rs. 5,000. Following a stock split in the ratio of 5:1, the share price would be Rs. 1,000. This makes it more affordable for prospective shareholders to purchase shares in the company, while the current shareholders can easily manage their portfolios.

Additional read: Types of stock trading

Key dates in a stock split

• Record date: The record date is when a company reviews its records to identify shareholders eligible for a stock split.
• Ex-split date:The ex-split date marks when the stock begins trading at the newly adjusted split price..

Existing shareholders will receive sub-divided shares credited with the new ISIN on the trading day following the record date.

Adjustment of Future & Options contract due to a stock split

Following the stock split, revisions to market lots and strike prices for F&O contracts using the stock as an underlying security will be determined by computing the adjustment factor.

For a stock split of A: B, the adjustment factor is (A/ B). For example, if the stock split ratio is 5:1, the adjustment factor is 5.

1. Futures/Strike price: You can find the revised futures/strike price by dividing the old futures/strike price with the adjustment factor.
2. Market lot: Similarly, you can determine the revised market lot by multiplying the old market lot with the adjustment factor.

To help you understand this better, let us take the example of TATA Steel, which opted for a stock split in the ratio of 10:1 in July 2022.

Before adjustment

The details before the stock split are shown below.

After adjustment

The details after the stock split adjustment are shown below.

Keep in mind that the investment or contract value of a futures or options contract remains unchanged after adjustment for a stock split.

Additional read What is Gross National Product

What is a reverse stock split?

While you now understand what a stock split is in the share market, you must also know about a reverse stock split. A company can also reduce its outstanding shares by increasing the share’s face value without reducing the market capitalisation.Similar to a stock split, the shareholder’s investment value remains unchanged by a reverse stock split.

Let us assume you hold 100 shares in a certain company (let’s call it ABC) at a share price of Rs. 10. Your total investment value in the company is 100*10 = Rs. 1,000. If the company opts for a reverse stock split in a 1:2 ratio, you will now hold 100/2 = 50 shares. However, your total investment value remains Rs. 1,000.

Thus, a stock split allows prospective investors to buy shares in the company and provides greater flexibility to the current shareholders, with more liquidity and ease of portfolio management. If you are looking to invest in a certain stock and it goes for a split, you can easily buy it at a lower price.

Advantages of stock splits

A stock split offers several benefits to companies and investors. Let us look at some of the key advantages:

1. Boosts liquidity

A stock split increases the total number of shares available in the market, which leads to higher trading volumes. It also increases liquidity, and investors can easily buy and sell the company's shares in the market.

2. Attracts new investors

As we know, after a stock split, the shares of a company are priced lower. The reduced price attracts investors who found the pre-split price too high. A broader investor base heightens demand, which increases the stock price.

3. Makes shares more affordable

Stock splits alter perceptions and create a sense of affordability. By reducing the capital layout per share, investors now feel the shares are within their means. For example, say a stock was priced at Rs. 3,000 before the split. After a 5-for-1 split, the price drops to Rs. 600. Now, the share seems more affordable to small investors.

4. Can increase the company’s market cap over time

Stock splits increase the number of outstanding shares, but that does not automatically increase the company’s market capitalisation. However, we have to consider the impact of a stock split on the market cap. For example, if perceived positively, it could attract more investors, resulting in increased share prices over time. In this instance, the company’s market cap can grow eventually.

Disadvantages of stock splits

Stock splits increase the demand for a stock by making it more affordable. However, there are a few downsides that market participants must be aware of:

1. No change in the value of a company

Despite being a major corporate event, a stock split doesn’t change the fundamental value of the business. The total market value, earnings, and financial health of the company remain the same before and after the split.

2. Increased volatility in the stock price

A stock split leads to greater fluctuations in the stock’s price. This volatility can increase the gap between buying and selling prices. Also, it creates more prominent short-term price changes, increasing the chances of sustaining losses, especially for retail investors.

3. Signals poor financial health

Sometimes, a stock split signals that the company is struggling financially. It shows that a company is not confident about its future prospects. As the stock market is highly sentimental, such a perception can negatively impact the stock price and investor confidence.

Example of stock splits

Example 1: Suppose the company ‘XYZ Limited’ announced a stock split at a 1:10 ratio. This implies each existing share with a face value of Rs. 10 was subdivided into ten shares with a face value of Rs. 1. The record date for this split was set for January 10, 2024. Before the stock split, XYZ Limited’s share price was approximately Rs. 25,000 per share. After the 1:10 stock split, the price per share adjusted to around Rs. 2,500. This move made the stock more affordable and increased liquidity in the market.

Example 2: Similarly, ABC Limited approved a 1:5 stock split, where each existing share with a face value of Rs. 10 was subdivided into five shares with a face value of Rs. 2 each. The record date was set for May 20, 2024. Before the split, ABC Limited's share price was Rs. 500. Following the split, the price per share would be approximately one-fifth of the pre-split price, making it Rs. 100 per share.

Conclusion

Stock splits make shares more accessible to a broader range of investors by making the shares more affordable. This reduction attracts more investors and enhances trading volumes. Also, it boosts liquidity and makes it easier for investors to buy and sell shares. However, it is crucial to understand that a stock split does not change the intrinsic value of the company. Instead, it simply redistributes the value across more shares. One major drawback is that companies declaring stock splits are sometimes viewed as financially unstable, reducing their stock price.