The advantages and disadvantages of stock splits offer insights into potential benefits for liquidity andaccessibility versus impacts on investor psychology and market perception. Understanding these aspectssheds light on the implications of this corporate action. Let's explore further.
- What is a Stock Split?
- Advantages of a Stock Split
- Disadvantages of a Stock Split
- Stock Splits Vs. Reverse Stock Splits
- Conclusion
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What is a Stock Split?
A stock split is a corporate action where a company increases the number of its outstanding shares while proportionally decreasing the stock price. This process does not affect the company's market capitalisation or its overall value. It involves dividing each existing share into multiple shares, adjusting the quantity but not the total value of shares held by an investor.
For instance, in a 2-for-1 stock split, shareholders receive two shares for every one they previously owned, effectively doubling the number of shares they hold. Simultaneously, the share price is halved to maintain the same total market value. So, if a company's stock was trading at Rs 100 per share before a 2-for-1 split, after the split, the price per share would become Rs 50, and investors would have twice the number of shares they had before the split.
Companies often opt for stock splits to make their shares more affordable for individual investors and potentially increase liquidity by attracting more investors. Additionally, a lower stock price might make the shares seem more accessible and attractive to a wider range of investors. Stock splits are cosmetic changes aiming to adjust share prices, maintaining proportional ownership and market value while aiming for increased market participation.
Advantages of a Stock Split
Now that you have understood the stock split meaning, let us discuss its advantages. A company might have a standard lot size for investors. Investors must purchase a minimum number of shares based on the lot size. However, investors find it difficult to purchase the standard lot when share prices rise significantly. In such a case, a stock split makes the standard lot more affordable for investors. Investors who could not purchase shares of a company due to high prices can afford them after a stock split.
It is crucial to note that a stock split also results in increased liquidity. Since stocks become more affordable after a split, more investors might be interested in trading. A stock split might also narrow the bid-ask spread in the market. Many companies depend on a stock split to attract new investors. When a stock becomes affordable after a split, it might lead to renewed investor interest in the stock market Also, there is no impact on the portfolio value of existing shareholders after a stock split. As you can see, stock splits benefit both the issuing company and potential investors.
Disadvantages of a Stock Split
Before indulging in a stock split, a company must understand the risks and challenges. A company cannot rely on a stock split to increase its value or market cap. A stock split divides the existing shares, thus keeping the market cap the same as before. Not to forget, a company must invest some amount to conduct a stock split. Regulatory compliance, news issues, and other activities in a stock split will require funds. The company must also be ready to hire legal support as and when required during a stock split.
Some public companies might attract the wrong audience with a stock split. For instance, a company might want to keep exclusive or HNI shareholders. However, everyone might be able to afford the company’s shares after a stock split. In such a case, shareholders of the company will no longer be exclusive. Another risk of a stock split is the reduction in the face value of a share. If the company’s performance plummets in the future, the face value will go down further in the market. When a company does not benefit from a stock split, it might be tempted to conduct a reverse stock split. However, a reverse stock split also involves legal support, expenses, and regulatory compliance.
Stock Splits Vs. Reverse Stock Splits
Both stock splits and reverse stock splits are popular corporate actions. Beginners in the stock market must understand the difference between the two actions. A stock split increases a company's existing number of shares. Since existing shares are divided based on the stock split ratio, the total number of outstanding shares increase On the other hand, a reverse stock split decreases the total number of company shares. Since shares are combined based on the reverse stock split ratio, the total number of outstanding shares decrease
Must Read: How Does the Stock Market Work?
Another crucial difference between stock splits and reverse stock splits is based on the share price. A stock split decreases the face value of a share in the market. It makes company shares more affordable for new investors. On the other hand, the face value of share increases after a reverse stock split. Retail investors might find it difficult to afford company shares after a reverse stock split as the price increases.
A company might opt for a stock split to increase liquidity and affordability of shares. Many companies opt for stock splits to renew investors' interest in the market. On the other hand, companies opt for reverse stock splits to prevent delisting from stock exchanges and boost the face value of the stock. Some companies might prefer reverse stock splits to attract elite or HNI investors who do not prefer low-value stocks.
Conclusion
Understanding the intricacies of stock splits unveils their potential advantages in enhancing liquidity, affordability for investors, and renewed market interest. However, these actions come with associated costs, regulatory requirements, and perceptions that might not always align with a company's strategic goals. Distinguishing between stock splits and reverse stock splits provides insight into their divergent impacts on share prices and investor appeal, aiding companies in making informed decisions aligned with their objectives.
