Stock Split: Features, Types, and Limitations

What is Stock Split?- Features, Types, and Limitations

1. What is Stock Split?

An investor, involved in online stock trading, may have at some point and time come across the term Stock Split. Even if while online stock trading one has not yet encountered the term, it is better to understand the concept and implications of the same.

A stock split is a method of increasing liquidity and making shares more affordable to a wide range of investors who previously couldn’t possibly afford the company’s equity due to high prices. In the event of a stock split decision by the company, the number of shares it has grows, but the value of market capitalization stays the same. Existing shares are halved, but the underlying value of the share does not get affected. As the number of shares increases, the price per share lowers.

Online share market trading is gaining prominence among retail investors with every passing day. Most of the reputed companies have their shares priced at higher denominations, this makes it a bit difficult for all the investors to afford the Stocks. Stock Splits may help retail investors to easily buy the shares of reputable companies.

2. Understanding the Stock Split

Depending upon the Stock Split form, the increment in the number of shares is decided. Stock Split can happen in any form as the company deems fit. Some common forms of Stock Splits are:

  • Two shares for 1
  • Three shares for 1
  • Five shares for 1

Essentially, Stock Split just increases the number of shares that an individual holds and not the value of the shares. A stock split enhances the liquidity of the shares. For example, let’s assume XYZ Ltd decides to split its shares, as five shares for 1. Earlier, the price of one share was Rs 50. Now, after the split, the same investor will have 5 shares of Rs 10 each.

3. Types of Stock Split

Stock Split types are nothing but the proportion in which the stocks are being split, therefore, there is no limit on the type of splits there can be. Some popular types of Stock Splits generally in practice are:

Two for One:

This means that existing outstanding shares will be divided into two shares for each share – simply doubling the shares without actually changing the value of shareholdings.

Three for One: 

Three for one Stock Split type entails that, without changing the value of shareholding, the number of shares will be tripled.

Five for One: 

It divides the value of one share into 5 shares, thereby increasing the number of shares in the same amount.

No matter the type of Split, it is imperative to understand that Stock Split does not change the value of shareholding, the split just happens in the number of shares.

4. Advantages of Stock Split 

Higher Liquidity:

One of the major advantages of the Stock Split is that it increases the liquidity of the stock. Retail investors involved in online share market trading can more actively trade the share due to reduced price per share.

Portfolio Management:

Portfolio Management firms and individuals managing a portfolio need to adjust the portfolio frequently depending upon the market conditions. Low-priced shares make it easier to do a proportional adjustment in the portfolio.

Share Price Increment:

Stock Split happens with the assumption that more players will be attracted towards the stock. The added interest in the entity often leads to an increase in the price of the share.

5. Disadvantages of Stock Split

Increase in share volatility:

As a stock split increases liquidity, the players involved in stock trading find it attractive. When more and more players get involved in the trading of a particular stock, it typically increases the volatility of the stock.

Capital erosion:

If a stock split occurs for a company with low consumer confidence, the heightened volatility and frequent swings result in an unstable market for the stock. This could result in a loss of capital for the investors.

PE ratio:

Many of the investors, involved in online stock trading, frequently follow company valuations for investing purposes. PE ratio is one of the financial parameters focussed upon by investors. Stock Split directly affects the PE ratio. Hence, investors relying on these ratios may not invest in the stock. 

6. Conclusion

Even though a Stock Split does not directly impact shareholdings, an investor should carefully analyse the split. Investors should try to understand the reason for the Stock Split and the expected outcomes of the split.

Companies take decisions to Stock Split for varied reasons, and it is often backed with expert analysis and insights. For a prudent investor, taking caution and understanding the logic behind these decisions is always advised.

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