Lets first understand what is Stock Split.
Assume that you billed someone with say $20. The payee offered you two numbers of $10 note. Would you accept it?
This question looks silly when it comes to notes but it makes a point when it deals with stock split.
In this article we will explain you what is stock split and what are its advantages for investors.
What is Stock Split?
Lets consider a situation in perspective…
Company doubles it number of shares outstanding in the market (N).
Simultaneously it also halves its stock price (P).
In this situation what happens to the market capitalisation?
Market Cap = No of shares x Price
- Case 1: MCAP_1 = N x P =
- Case 2: MCAP_2 = (N*2) x (P/2) = N x P
The market cap in both the cases are same.
In this condition, the stock has been split.
- More in quantity.
- Less in price.
The split stock’s market capitalisation remains same.
When one stock is divided into so as to lower its price is called stock split.
The only change is, in the number of stocks outstanding in the market.
Example_1: Stock Split of 1:3
When there is a stock split of say 3:1, it means each investor will get two stocks for each single stock they own.
Simultaneously, the value of stock is reduced by one third.
N x P = (Nx3) x (P/3)
Example_2: Stock Split of 1:2
When Stock is Split in Ratio of 1:2
N x P = (Nx2) x (P/2)
Example_3: Live (1:3)
Let’s take example of a stock say X.
Suppose it has a trading value of say $12. It this stock is split in ratio 3:1.
It means one will get 2 additional stock for each one.
After stock split, the investor will have 3 nos stocks for each one in hand.
The price of this stock will become one third ($12/3 = $4).
The market capitalisation (stocks market value) remains unaltered:
Stocks Market Value = 1 no x $12 = (1 x 3 nos) x ($12 / 3) = $12
Why companies do stock split?
We have already seen that stock split does not change stocks market value.
So why actually companies go for the stock split, what are its advantages?
There can be several reasons why a company may opt for the stock split.
The first and foremost reason is that it allows companies to keep stock price in comfortable zone.
It is investors psychology that keeps them from selecting a stock whose market prices is too high.
A quality stock which whose market price is low will be traded more frequently.
More and more small / part-time investors will be able to trade a stock which has smaller market price.
Suppose a blue chip stock is trading at $100.
Another blue chip company is trading at $10.
Then it is common to observe that, the stock with $10 will trade more (will have higher trade volume).
What are the advantage of stock split for investors?
There is no advantage of stock split for investors.
The true value of stock remains unchanged after stock split.
But it is also a fact that the speculative advantage of stock gains dominance due to stock split.
Due to low market price of stocks there will be more trading of that stock in the market.
Non trained investors will mistake high market priced stocks as overvalued.
The only advantage that companies has post stock split is to psychologically influence investors to buy their stock.
The true value of stock does not change because of the stock split.
So basically there is no advantage for stockholder because of stock split.
Stock split can give no advantage to the investor. Why?
Because due to stock split, the EPS, Book Value per share, intrinsic value, etc also plummets.
Except for the fact that low priced stock (like penny stocks) are traded more frequently.
So to conclude, as two numbers $10 note and one $20 note has no difference, similarly stocks before and after split is the same.
Investors shall not worry or get excited about stock splits.
Instead they shall focus on knowing about the true value of stock.