Overview Of Stock Split

Overview Of Stock Split

Companies invest in stock market strategies in a number of ways to gain the maximum amount of profit for the company and its shareholders. These plans and strategies are also known as corporate action.

One such corporate action is the stock split. A stock split can be defined as a corporate action initiated by a company by dividing a portion or a ratio of the company's shares, which leads to a rise in the total number of shares of that particular company or corporate group. 

An action of the stock split also leads to a downfall in the share price and the company's face value or corporate group. It is important to note that the ratio of the downfall or decline in the company's share price and face value is equal to the ratio of the stock split.

In other words, the more a corporate group divides or splits its existing shares, the more the share price and the face value of the corporate group shall fall. 

You can refer to the following example for better understanding the concept of stock split and its effect on the decline in the share price and face value of the company:

  • Let us assume that we have 20 shares of a company called AB Ltd.
  • Now, let us also assume that the share price of AB Ltd equals 1000 Rs and the company's face value equals Rs 10.
  • As per this assumption, our investment value is in AB Ltd. It equals Rs 20,000 (multiplying 20 shares with the share price, i.e. 1000).
  • Now, let us further assume that AB Ltd. Has decided to split the stocks in a ratio of 2:1
  • This would directly imply that all of the stocks held by AB Ltd. have now been divided in half.
  • This would also imply that the share price and the face value of AB Ltd. will now drop by 50%.
  • And finally, due to the splitting of the stocks, the earlier shares owned by us, i.e. 20 shares, have now been divided into 40 shares. Also, the share price of AB Ltd. is now Rs 500, which makes the face value of the shares drop to Rs 5.

Hence, the ratio of stock split performed by AB Ltd. will make the company's shares divided into the same amount. For instance, a stock split of a ratio of 5:1 will divide the shares of AB Ltd. into 5 halves and so forth.

The division of shares will thus have an inverse impact on the share price and the company's face value.

Why do companies stock split?

Companies usually perform the corporate action of a stock split for the following reasons:

Affordable shares: It is pretty obvious that the more affordable the price of the shares are, the more other companies, corporate groups, and individuals would be willing to buy and invest in the stocks of a particular company.

Hence, by making the price of the shares more affordable, the companies try to lure potential corporate groups and individuals to buy and invest in their stocks as much as possible.

Competition: The stock market is pretty competitive, and competition amongst potentially rival corporate groups and businesses is yet another reason for companies performing the corporate action of a stock split.

Suppose a corporate group realizes that the prices of the shares of their rivals in the business world are significantly lower than their share price. Then a corporate move like a stock split becomes necessary to keep their existing investors engaged in investing in their shares and also to lure other potential individuals and business groups.

Rise in demand: The corporate action of a stock split is also a smart move for the companies to indirectly raise the prices of their shares after dividing the prices of their shares voluntarily.

Stock split leads individual investors and potential corporate groups to view the share price of a company as affordable, which in turn raises the demand of the shares of the company and finally leads to a rise in the prices of shares of that particular company.

Manifesting positivity: The corporate move of a stock split, in general, sends a positive message amongst the investors that with the division of shares, the share price of the company will potentially arise in the future (as discussed in the point mentioned above), which will eventually prove to be beneficial for the investors.  

Reverse stock split

So far, we have discussed the concept of a stock split. It must be pretty clear by now that the corporate action of a stock split, in the long run, benefits both the company and the corporate group performing the stock split and the investors who have bought the shares and invested in the stocks of the same company.

The reason for a company or a corporate group to perform the move of a reverse stock split is completely opposite to the reason for performing a stock split. But let us first clear the concept of a reverse stock split:

“Reverse stock split can be defined as the corporate action when a company voluntarily drops its number of shares which ultimately leads to a rise in its share price”.

A company may act as a reverse stock split for the following reasons:

  • When a company or a corporate group realizes that the prices of its shares have potentially reached too high, performing a reverse stock split can be the right move to stay in the competition.
  • Companies also perform the move of a reverse stock split when they notice that their rival companies' share prices are potentially higher compared to the prices of their shares.

You can refer to the following example to better understand the concept of a reverse stock split:

  • Let us assume that we have purchased 100 shares of a company called AB Ltd. 
  • Let us also assume that the share price of AB Ltd. is Rs 10 and the face value of the shares is Rs 2.
  • This implies that our investment value in AB Ltd. is 1000 Rs. 
  • Now, assuming that AB Ltd. decides to perform a reverse stock split of 1:5, this would imply that every 5 shares of AB Ltd. will now be merged into a single share.
  • This would lead to a 5x rise in the share price and face value of the shares of AB Ltd. 
  • Hence, after AB Ltd. performs the reverse stock split, we would now have 20 shares left of the company (1/5th of 100).
  • This would potentially raise the share price of AB Ltd. to Rs 50 and the face value of the shares to Rs 10. 
  • However, the reverse stock split action does not affect our investment value.

Conclusion

The corporate action of a stock split can be defined as the voluntary decision of a company to divide a certain ratio or portion of its share to benefit from the potential rise in the prices of its shares in the future due to a rise in demand for its shares.

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