A large number of stocks of different companies are traded in the stock market. While some are traded at lower rates, some highly valued stocks come with a high price per share.
To make these shares more accessible to investors and to improve their liquidity, companies tend to employ a stock split strategy. Let us see how it works.
What is stock split?
Stock split is a strategy employed by companies to increase the number of outstanding shares issued by them by splitting the existing shares into shares of smaller denominations. The number of shares in the hands of existing shareholders increases while the total value of shares they hold remains the same. Stock split does not lead to any change in the company’s market capitalisation.
Let us understand this with an example.
Assume you hold 10 shares of X Ltd., where each share is of Rs. 200. You thus hold shares with a total value of Rs. 2,000. Now, X Ltd. decides to split its shares by employing a 2-to-1 stock split strategy. Each share you hold will be divided into two, and the share price will be split in half. Therefore now, you will have 20 shares of X Ltd, each valued at Rs. 100. The total value of shares you hold will remain the same at Rs. 2,000.
Why do companies split their stocks?
There are many reasons why companies decide to split their stocks. A few of them include:
With a split in stocks, the price of an individual stock comes down. This makes the stock more attractive for investors as it becomes more affordable. For instance, a high performing stock of a reputed company may be beyond the investment range of an investor. The price is slashed with a stock split, allowing such investors to obtain them. This effectively increases the demand for the stock in the market, which reflects well on the share price as well.
To improve liquidity
Shares with a high price are not easy to trade as they require a large sum to be invested. This reduces the overall trading volume of such shares. On the other hand, shares with a lower price are easier to buy and sell. The ability to frequently and easily exchange such shares in the market improves their liquidity. Because of this, the spread, which is the difference between the bid and ask price, tends to reduce. A lower spread means better prices for the investors.
Read more about stock liquidity in our blog on How to Assess Liquidity in Stock Investments here.
To make it easier to rebalance the portfolio
It is a crucial task to keep updating and rebalancing your portfolio. This can be done with the help of professional portfolio managers as well, who keep a tab on everyday fluctuations in the stock market. It is easier to rebalance your portfolio when the stocks are of lower denominations, as it becomes easier for you or your portfolio manager to sell the shares. Moreover, each trade accounts for a smaller percentage of your total portfolio, making it easier to manage and rebalance it.
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While not every stock split results in an increase in the share price, a higher price of the share is a likely outcome after such a strategy is implemented. With a lower per-share price, the demand for the share shoots up, and so does its trading volume. The shares become more affordable and lucrative, attracting many investors to invest in them.
All of these reasons influence a company to use the stock split strategy. Now that we have understood the reasons behind the splitting of stocks, let us see how it impacts your portfolio.
How does a stock split impact your portfolio?
A stock split does not immediately impact the value of the shares you hold. While the number of shares you hold increases, the price per share is reduced. However, as the shares become more attractive to investors, chances are the share price will soar in the future. You can benefit from the overall increased prices, as the value of your holding appreciates with time.
Apart from this, a stock split announcement could be an excellent opportunity for you to invest in shares that were earlier out of your investment budget. It allows you to further diversify your portfolio and venture into new sectors in the stock market.
Learn more about portfolio diversification in our blog on stock investing in India – what is portfolio diversification in the Teji Mandi blogs.
How are dividends affected by stock splits?
In most cases, the dividends declared after a stock split are adjusted in a way that the total amount of dividends announced remains the same. This involves reducing the dividend per share as the number of outstanding shares increases.
For instance, X Ltd. annually declares a total dividend of Rs. 20 lakh for its shareholders. Prior to a stock split, the number of shares outstanding is 10 lakh; thus, a dividend of Rs. 2 per share is paid out. After a 2:1 split, the outstanding shares increase to 20 lakh. Thus, the dividend becomes Re. 1 per share. Even though the amount of dividend per share falls, the total dividend paid out remains unchanged.
However, most companies decide not to split shares close to the date when a dividend is to be declared. This helps in avoiding any confusion regarding the same.
In conclusion
Stock split is a valuable and common strategy employed by companies where they split their existing shares by reducing the price per share and increasing the number of outstanding shares. This strategy has no impact on the company’s market capitalisation, and the portfolios of investors remain largely unaffected. However, it makes the shares more attractive due to the split price, thus making them more accessible for investors to put their money in.
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