Understanding a Stock Split

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The stock market is very much in the news. Even common people take an interest in the stock market and also make investments. Recently a friend of mine informed me that one of the companies whose shares he held had decided to split his shares into two. He was a little perturbed as to what it meant. Would his market capitalization go down or would it affect him in any other way?

The fact is that many people invest in stocks and shares, but there are a few who need to know more about the stock market. On of the prominent steps in managing a capital of a company is by a stock split. A stock split in real terms means that a company decides to split an existing share into smaller denomination. A company may decide to split its stock by giving its stock holders twice as many shares to the number already held. People who hold the stock of a company are called stock or share holders and by virtue of owning the stock are also owners of the company in relation to the number or value of stocks held by them.

A decision to split stock can only be by a decision by the company’s board of directors. They are the only competent authority to order a split in stock. The basic aim is to increase the number of shares, while the number of stock holders will remain the same. The stock split is always applicable to the current owners of the shares. For this purpose a record date is specified and published and this is the date that identifies the owners on that date who are entitled to the stock split.
A stock split should not be confused with bonus shares. Bonus shares are shares that are additional shares allotted to a share holder and their face value is the same as ordinary shares. But in the case of stock split the value or face value of a share goes down. For instance a stock split could be in the ration of 1:2 or 1:3 or any other ratio. This means that a share holder is given additional shares in the ratio specified and more important the face value of the share is reduced as per the ratio authorized. Effectively it means that share of the face value of $10 is reduced to a share value of $5 in case the split authorized is 1:2. Similarly the share value will be $2.5 in case the split is in the ratio of 1:4.The point to be noted is that though the number of shares is increased, the market capitalization of the company remains the same.

Why a Company will  Split its Stock?

A question that may well arise is to the reason a company may authorize a stock split. The basic aim is to increase the liquidity of the stock, in case the share price has shot up. Thus a share price $100 may be split to say$25 to make it easier to trade on the stock exchange. In principle this is a good thing as more investors will buy the AND THE company gains by greater participation of the investors and its financial health improves. Stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their sector. An important effect of a stock split is the greater liquidity and an increase of the share value on the stock market as more investors can buy the affordable shares. This benefits the small investor.

Reverse stock splits can also take place but they are not that common. The reasons are the reverse as the share price could be low and people may be considering the stock as a poor investment.The company could also be attempting to thwart a delistment on the stock exchange

Last Word

But we can summarize by mentioning that a stock split is used primarily as a ploy to increase liquidity of the stock once the share price rises inordinately. It is a benefit to the small investor and also helps the owner to dispose off his stock more easily. The market capitalization of the company does not change.


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