Stock split is an absolute favourite amongst retail investors. Even a rumour about a company announcing a stock split is enough for the stock price to rise rapidly with everyone looking to buy the shares to benefit from the stock split. You buy one share today and you get multiple shares after a few days. Who wouldn’t like such a good deal!?
To view corporate announcements regarding stock split and much more, visit NSE official website!
But the reality is – stock split doesn’t change the value of the company and doesn’t really mean anything fundamentally!
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What is stock split?
Stock split refers to a company increasing the number of stocks in the market by reducing the face value of each stock. E.g. if a company announces a 1:5 stock split where the face value of the stock is Rs. 10 and the current value of the stock is Rs. 10,000, then after the split (assuming stock price doesn’t change) investors will have 5 stocks for every single stock held with a face value of Rs. 2 and a stock price of Rs. 2000.
This might seem like a good deal at first glance. Every investor now has five times the amount of stocks which they had before the stock split. But has anything really changed fundamentally? The value of the company as well as every investor’s holdings has not changed at all!
Nothing changed fundamentally
Let’s consider an example. Suppose a company has a total of 10,000 stocks and you own 100 stocks of that company. That makes you a shareholder of the company who has a 1% stake in the company. If the company announces a 1:5 stock split, every single stock gets split into 5 stocks. So the total number of stocks are now 50,000 (previously 10,000) and you now own 500 stocks (previously 100). But you still own 1% stake in the company! Absolutely nothing has changed fundamentally and the value of the company remains exactly the same. You previously had a 1% stake in the company and you still have a 1% stake in the company regardless of whether the stock gets split into 2, 5, 10 or 20 pieces.
Then why is a stock split celebrated?
A stock split might not do much for the company fundamentals but it is a huge boost to the sentiment. Sentiment is an essential part of the stock market which moves the market much more easily than the fundamentals. This is why a boost to the sentiments due to the news of stock split sends every investor into a buying frenzy.
There are three reason why stock split can drive up price in the short term –
- Reduced stock price – This is an important factor for retail investors and traders who want to start their stock market journey with a small capital. If a stock is trading at Rs. 25,000 per share, this can sometimes make it difficult for retail investors with a small capital to buy the stock. However if this stock were to split in a 1:10 ratio, retail investors can buy the new stock for Rs. 2500 which makes it more affordable. There are some people who think that the stocks which have a lower price are cheaper and have a higher chance of profit. However, that is simply not true and the stock price is not cheaper because the fundamentals are exactly the same!
- More volume – Stock split means more volume in the share which attracts more traders. Traders love shares which have more volume because it allows an easier entry and exit to the trade. After the stock split, traders can generally become active in the stock which also moves the stock price up. If you want to learn why volume is important for stock trading, visit this article!
- Expectations of good things to come – When a company announces a stock split, it is generally because the price of the stock has become very high and that can make it difficult to trade. A company which announces a stock split sends a clear message to investors that the price of the stock can go up even higher which is why the stock has been split to make it more affordable and tradable. Expectations over further price increase send the price up because everyone wants to get a quick profit.
Profit booking after stock split
It is observed many times that big players and funds start to book profits after the stock split actually happens or is about to happen. This is because the same company in which no fundamentals have changed, is now trading at a much higher price even if the price per share looks cheap. This provides a good time for many big investors to do profit booking to take advantage of the euphoria which the stock split has created without any backing of the company fundamentals! In my opinion, it is generally a bad idea to directly jump into the stock as soon as the split is announced. However, the readers are advised to make their own decision based on their own analysis!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
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