What are Stock Splits?
The term “stock splits” refers to the corporate action wherein a company divides each stock into multiple stocks to enhance the marketability and liquidity of the stocks. In this process, the number of outstanding stocks increases manifold based on the ratio of the split, but the total dollar value of the outstanding stocks continues to remain at the pre-split level.
Explanation of Stock Splits
The underlying principle of stock splits is based on the inherent human psychology of most investors, who find it less risky to purchase 100 shares worth $10 per share compared to 10 shares worth $100 each. As such, most publicly listed companies tend to split their stocks when their share price surges substantially. This way, they lower the share price, making it more affordable and liquid.
How does Stock Splits Work?
The companies decide to split their shares to lower their trading price and bring it to a comfortable level for most investors. Based on the split ratio (say 2 for 1 split), each stock price drops by a certain multiple (2x). In such a scenario, the investors find the stock price more affordable (half as compared to the pre-split level). Therefore these investors are more likely to purchase the shares, which increases the shares’ liquidity. However, given that stock splits don’t add real value to a company’s market capitalization, the total market capitalization post-stock split remains at the same pre-split level.
How to Calculate Stock Splits?
Let us look at the various calculations involved in stock splits.
- Step 1: The decision of stock splits, including the split ratio, is taken by the company’s board of directors. In this case, let us assume that the stock split is N for 1, which means that investors will receive an ‘N’ number of shares in exchange for each share they hold.
- Step 2: Accordingly, the number of outstanding shares will increase by multiple ‘N’as shown below.
- No. of outstanding shares after split = N * No. of outstanding shares before the split
- Step 3:On the other hand, the Price per share will drop by a multiple of ‘N,’ as shown below.
- Price per Share After Split = Price per Share before Split / N
Examples of Stock Splits
Following are examples of stock splits given below:
Example #1
Let us take the example of a company that has decided to go for a 10-for-3 stock split, which means that there will be ten shares in place of every three shares after the split. Determine the outstanding number of shares and new share price post the stock split if currently there are 3,000 shares outstanding and the market capitalization is $6,000,000.
Solution:
- Given No. of outstanding shares before split = 3,000
- Market capitalization = $6,000,000
- Split ratio, N = 10/3
Share price before the stock split can be calculated as,
Price per Share Before Split = Market Capitalization / No. of Outstanding Shares Before Split
- Price per Share Before Split = $6,000,000 / 3,000
- Price per Share Before Split = $2,000
The outstanding Number of Shares After the Stock Split is calculated using the formula below.
No. of Outstanding Shares After Split = N * No. of Outstanding Shares Before Split.
- No. of Outstanding Shares After Split = 10/3 * 3,000
- No. of Outstanding Shares After Split = 10,000
Share Price After the Stock Split is calculated using the formula given below.
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Price per Share After Split = Price per Share Before Split / N
- Price per Share After Split = $2,000 / 10/3
- Price per Share After Split = $600
Therefore, the outstanding number of shares and new share price post the stock split will be 10,000 and $600, respectively.
Example #2
Let us take the example of Netflix, which went in for a 7:1 stock split in the year 2015 (https://www.businessinsider.in/tech/Netflix-is-splitting-its-stock-7-ways/articleshow/47792745.cms). During the time of the split, each Netflix share was trading at $702.6 per share, which made it one of the expensive stocks in the S&P 500 index at that time. So, the stock split aimed to make the shares more appealing and attractive to small investors. Determine the share price after the stock split.
Solution:
- Given, Price per share before the split=, $702.6
- Split ratio, N = 7
The Price of Each Netflix Stock after the Stock Split is calculated as follows,
Price per Share After Split = Price per Share Before Split / N
- Price per Share After Split = $702.6 / 7
- Price per Share After Split = $100.4
Therefore, the value of each Netflix share after the stock split was $100.4.
Forms of Stock Splits
The stock splits used by the corporates can be broadly categorized into the following two forms:
- Forward stock split: It refers to the usual stock split discussed above. In other words, it is the division of a highly-priced share into multiple lowly-priced shares.
- Reverse stock split: It refers to the corporate action wherein the number of outstanding shares of a company is reduced by merging multiple shares into a single share. During unfavorable market conditions, this process is used to support share prices.
Advantages
Some of the significant advantages of stock splits are as follows:
- The share price gets reduced and becomes more affordable for smaller retail investors.
- A stock split is usually seen as an indication of a growing company.
- In some instances, the existing shareholders receive bonus shares during stock splits.
Disadvantages
Some of the significant disadvantages of stock splits are as follows:
- Convenient trading results in a surge in investors, leading to stock price volatility.
- Stock splits come with additional costs, such as legal costs, banking charges, etc.
- It is a challenging task for analysts to analyze such companies due to several value adjustments.
Conclusion
So, it can be seen that stock splits play an essential part in the share trading of a company. Further, investors also view these stock splits as a forward indicator of a rapidly growing company.
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