What is Stock Splits?
The term “stock splits” refers to the corporate action wherein a company decides to divide each stock in the company into multiple stocks in order 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 as compared to 10 shares worth $100 each. As such, most publicly listed companies tend to split their stocks when their share price surges substantially. In this way, they bring down the share price to make it affordable and more liquid.
How does Stock Splits Work?
The companies decide to split their shares to lower their trading price and bring it to a level that is considered comfortable for most investors. On the basis of 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), and therefore these investors are more likely to purchase the shares, which in turn increases the liquidity of the shares. However, given that stock splits don’t add any real value to a company’s market capitalisation, 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 the process of 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 ‘N’ number of shares in exchange for each share held by them.
- 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 the examples of stock splits are given below:
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 10 shares in place of every 3 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.
- 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
Outstanding Number of Shares After the Stock Split is calculated using the formula given 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.
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.
Let us take the example of Netflix that 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 was aimed at making the shares more appealing and attractive to the small investors. Determine the share price after the stock split.
- Given, Price per share before split= $702.6
- Split ratio, N = 7
The price of Each Netflix Stock after the Stock Split is calculated as,
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
- Reverse stock split
- Forward stock split: It refers to the usual stock split that has been 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. This process is used to support share prices during unfavourable market conditions.
Some of the major 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 certain cases, the existing shareholders receive bonus shares during stock splits.
Some of the major disadvantages of stock splits are as follows:
- Convenient trading results in a surge in the number of investors, which in turn leads to stock price volatility.
- Stock splits come with the burden of various additional costs, such as legal cost, banking charges etc.
- It is a challenging task for analysts to analyze such companies due to several value adjustments.
So, it can be seen that stock splits play a very important part in the share trading of a company. Further, investors also view these stock splits as a forward indicator of a rapidly growing company.
This is a guide to Stock Splits. Here we also discuss the introduction and how does stock splits work? Along with advantages and disadvantages. You may also have a look at the following articles to learn more –