Thursday, September 3, 2015

Stock Split - Concept And Example

A stock split is a term used to denote a situation where a company increases the number of its shares outstanding by reducing the face value of its shares.

The concept of stock split can be better understood with an example:

Let us assume that the shares of QR Ltd are currently quoting at Rs. 1500 per share. The face value per share is Rs. 10. The company decides to go for a 5:1 stock split.

The existing shareholders of the company will receive 5 shares of face value Rs. 2 each in lieu of every share of the face value of Rs. 10 held by them. Note that the market price of the shares will drop to Rs. 300 per share post the split. [1500 divided by 5 gives us 300]

Why do companies go for a stock split?

Companies go for a split to make their shares more accessible to small investors. Let us continue with the above example.

Mr A is an average small investor willing to invest Rs. 6000 into the stock markets. If he invests his entire capital in the shares of QR Ltd at the pre-split market price of Rs. 1500 per share, he will receive only 3 shares in his kitty.

On the other hand; post-split (when the market price of the share drops to Rs. 300), he will receive 20 shares for his investment.

Thinking from a Psychological aspect, a small investor will be more inclined to buy 20 shares of Rs. 300 each than just 3 shares of Rs. 1500 each.

Thus a stock split makes the shares of a company more attractive to small shareholders and thus brings about an increase in the liquidity of the shares.

How does a stock split affect shareholder's wealth?

A stock split has NO effect on the shareholder's wealth as it bring no additional resources at the disposal of the firm.

However, as I had alluded to earlier a split does make a shares of a company more accessible to small shareholders and thus leads to an increase in the volume of the shares traded.

This might have an indirect impact on the market price of the shares as investors who earlier considered a share out of their reach will now start buying and selling them - thus impacting  the price of the shares in the long run!

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