Many corporate actions take place in the world of the stock market. A stock split is also a corporate action. Today, let’s explore what is a stock split and how does it affect you as an investor? Let’s begin.
What is a Stock Split?
A stock split is nothing but dividing one share into multiple shares. Now, the question of why a company decides to split a stock is something we will discuss later. But, first, let’s understand the concept better.
Let’s assume we give you two options to choose from a 5 kg cake or a 100-gram pastry of the same cake. Now, the condition is such that you have to choose any one of these and eat it all at once.
Most of us would prefer a 100-gram pastry over a 5 kg cake!
Now, this situation is very similar to a stock split. Just as a person might have to face various difficulties to have a 5 kg cake all at once. Hence, a big cake is sliced into small consumable pieces called pastries.
Similarly, an investor will have to face many difficulties buying an expensive stock. And hence, the stock is broken down into more shares so that it is affordable for investors to buy.
Let’s take an iconic example of a stock split.
We all know the legendary investor Warren Buffett and his owned company Berkshire Hathaway.
Berkshire Hathaway shares are trading at $4,36,201 as of 26th August 2022. This means that to own one share of the company, you will have to spend Rs 3,49,15,098.36 (as of 29th August 2022).
Spending such a huge amount to buy one share of the company is next to impossible for most people worldwide. Hence, the company split the shares into groups A and B. While group A remained unchanged, group B went through a stock split.
Throughout this time, this is how group A shares were performing.
As you can see, in 2010, the share price of group A was trading at $1,20,000 per share which is 1,500 times that of group B.
For retail investors, buying a stock for $80 is much more affordable than buying a stock for $1,20,000. And to make the stock affordable and tradable, a company decides to undergo a stock split.
Now, stocks could be split into ratios like a 2-for-1 split, 3-for-1 split, 2-for-3 split, 10-for-1 split, etc.
Why Does a Company Decide to Undergo Stock Split?
Just as we saw in the case of Berkshire Hathaway, a retail investor can’t even imagine buying group A stock. Why? Simply because it is expensive!
But, if we look at group B, which is trading at $289 or Rs 23,140.81 as of 26th August 2022 is relatively affordable.
If we take an example of an Indian company, the most popular and recent example is IRCTC. It had announced a stock split when its share price was trading at around Rs 4,500 with a face value of Rs 10. Later, it went through a stock split in the ratio of 1:5. So, if you had a share of IRCTC, it will automatically convert to 5 shares at Rs 900 each with a face value of Rs 2.
So, the stock split cuts a share into small pieces and makes it affordable.
When the share price is too high, there are limited numbers of shares floating in the market. Hence, investors face the problem of liquidity. Well, this means that if you wish to buy shares of a company, there are fewer to no sellers available, or you can say that the share is illiquid.
To eradicate this problem, the company splits a big share into biteable pieces, which increases the outstanding floating shares so that investors can trade easily.
Remember that the market capitalisation of the share would remain the same even after a stock undergoes a split.
Impact of a Stock Split
Now, when a company splits, it will not affect the value of an investor’s holdings.
Let’s assume that you own shares of ABC Ltd.
Now, the share splits in the ratio of 2:1. This means that every share you own will be split into two, and the face value will be adjusted accordingly. After the stock split, this is what your portfolio would look like:
As you can see, your total investment value has remained the same after the stock split. So, a stock split will not make you richer.
Conclusion
Many investors have a misconception that the share price would rally or fall after a stock split. But that’s not the case. A stock split does not indicate that the company’s fundamentals have changed. So, it would be best if you never let the stock split influence your decision to buy or sell a stock.
*The stocks mentioned in the article are for informational purposes. This is not investment advice.
