Stock Split: Types, Advantages and Disadvantages

A stock split is a corporate action that involves dividing existing shares into multiple new ones. 

But why would a company do so?

Splitting stocks results in an increase in the number of outstanding stocks and this corporate action is inspired by a company’s desire to boost the stock's liquidity. The primary goal of a stock split is to increase the affordability of a stock by decreasing the per-share price. 

The common ratios for stock split are a 2-for-1 or 3-for-1 split. To illustrate, in a 2-for-1 stock split, each shareholder receives two shares for everyone they already own, halting the price of a single share.

While this may seem similar to a bonus issue, that isn’t true. Stock split and bonus issues are different strategies meant for different organisational objectives.

How Does a Stock Split Work?

Let us look deeper into the working of a stock split:

When a company's board of directors decides to make its stock more affordable for people, they announce something called a "stock split." This strategy is primarily aimed at increasing the stock's attractiveness so that more investments flow in. This announcement usually comes a few weeks before the actual split happens, giving current investors time to prepare and potential investors a heads-up.

Now, the way it works is like this:

Let's say a company does a 2-for-1 stock split. If you own 50 shares of that company's stock, and each share is worth Rs.50 before the split, after the split, you'll have 100 shares, but each one will be worth ₹25. It's like cutting a pizza into smaller slices to make it easier for more people to get a piece. So, in the end, you still have the same total value of the investment, but you just have more shares, and each share costs less.

The following example shows a stock split in 2:1 ratio:

Scenario	Before Split	After 2:1 Split
Face Value (FV)	₹20	₹10
Number of Shares Owned	50	100
Share Price	₹400	₹200
Investment Value	₹20,000	₹20,000

In this case, the face value decreases, the number of shares owned doubles, and the share price halves, but the total investment value remains constant at ₹20,000. This demonstrates the impact of a 2:1 stock split.

Why Companies Issue Stock Split?

A company might choose to double or triple its outstanding stock shares through a stock split, even if its market capitalisation remains unaffected, for a couple of key reasons:

Perceived Affordability:

When a company's share price is high, it might discourage some investors from buying its stock because it seems too expensive. The company effectively lowers the per-share price without changing its overall value by doing a stock split. This perceived affordability can attract more investors, as the stock appears less risky when it is more within reach financially.

Liquidity and Accessibility:

Lowering the share price through a stock split can enhance the stock's liquidity. With a lower price, more investors, especially those with limited funds, may find it easier to buy into the company. This increased accessibility can potentially broaden the shareholder base and generate more trading activity in the stock.

Types of Stock Split:

1. Forward Stock Split:

Forward stock splits can take many forms but the most common are two-for-one, three-for-two, and three-for-one. When a company undergoes a forward stock split, it takes a couple of actions to make its shares seem more accessible to small investors:

• Issuing Additional Shares:

The company increases the total number of outstanding shares by giving existing shareholders additional shares. This effectively dilutes the ownership of each existing share.

• Natural Price Drop:

The increased number of shares leads to decreased share prices. However, the company's overall valuation and market capitalisation remains the same.

2. Reverse Stock Split:

In contrast, a reverse stock split involves reducing the number of shares. Here's how it works:

• Decreasing the Number of Shares:

The company decreases the total number of outstanding shares. For example, in a 2-for-1 reverse stock split, you end up with one for every two shares you own.

• Adjustment of Share Price:

While the number of shares decreases, the value of each share increases proportionally. So, if your shares were worth Rs. 4 each before the reverse split, and you end up with fewer shares after the split, say Rs. 8 each, the total value of your investment remains the same. It's a way of consolidating shares without changing the overall value. 

Advantages of Stock Split:

Below are some advantages that a stock split unlocks:

• Enhanced Accessibility:

A stock split facilitates enhanced accessibility to the company's shares by reducing the individual share price. This strategic move aligns to broaden the investor base, ensuring that shares remain within reach for diverse market participants.

• Improved Liquidity:

Lowering the share price through a stock split improves liquidity dynamics. This heightened liquidity is instrumental in fostering a more fluid trading environment, allowing for increased buying and selling activities and contributing to market efficiency.

• Perception of Attractiveness:

A stock split often conveys a strategic effort to enhance the company's perceived attractiveness in the market. The resulting lower share price can make the stock appear more appealing to a broader audience of investors, contributing to heightened market interest.

• Psychological Impact on Investor Sentiment:

Beyond numerical adjustments, the psychological impact of a stock split plays a significant role. The reduced share price can positively influence investor sentiment, creating a perception of affordability and approachability, thereby attracting a broader investor community.

• Facilitation of Employee Stock Participation:

Companies undertake stock splits with a strategic eye on facilitating employee stock participation. The lowered share prices resulting from the split ease accessibility for employees to engage in stock option programs and align their interests with the overall corporate trajectory.

• Strategic Positioning for Future Growth:

A stock split can strategically position the company for future growth. By making shares more accessible, the company can potentially attract a broader investor base, fostering increased demand and contributing to the company's expansion plans.

• Maintained Proportional Ownership for Shareholders:

Existing shareholders retain their proportional ownership following a stock split. This strategic move ensures that the intrinsic value of shareholders' holdings remains intact, emphasising the equitable distribution of the company's value among its investor base.

Disadvantages of Stock Split:

Below are the notable disadvantages of a stock split:

• Consistent Company Value:

A stock split doesn't alter a company's fundamental value—metrics like market capitalisation and earnings stay constant.

• Increased Volatility:

Stock splits can introduce higher volatility, leading to wider bid-ask spreads and increased short-term trading volatility.

• Perception of Financial Strain:

In certain cases, a stock split may be seen as a sign of financial strain or low confidence, potentially impacting the stock price and investor sentiment.

Impact of Stock Split on Investors:

When a stock undergoes a split, the total value of your holdings in that stock typically remains unchanged. The number of stocks in your portfolio increases or decreases, but the adjusted stock price ensures the overall value stays the same.

For instance, having a single share valued at ₹100 is essentially the same as possessing two shares priced at ₹50 each. The overall financial benefit to shareholders doesn't change because of this. You may hold more shares post-split, but their individual value is halved, so the total investment value remains constant.

However, there's a common belief among investors that stock splits, over time, might actually enhance value. This stems from the idea that a lower share price post-split can make the stock more accessible to a broader range of investors. This increased accessibility can potentially drive the stock's price up due to heightened demand.

This point illustrates the case of Nestle India, which executed a stock split in a 1:10 ratio on January 5 as the record date. If you held one share of Nestle India on that date, you would have ten shares after the split.

Such splits can spark new interest from investors, especially retail shareholders, who now view the stock as more affordable and within their reach to purchase.

Bottom Line:

A stock split is a tactical decision made by companies experiencing substantial share price growth. Despite the increase in the number of shares and the decrease in the price per share, the overall market capitalisation remains steady. 

Consequently, while a stock split does not inherently increase shareholder value, it does make the stock more accessible to smaller investors. This increased accessibility can enhance the marketability and liquidity of the stock in the marketplace.