What is a Stock Split: Why Companies Split Their Stock 

For investors holding company stock, a stock split is an important activity that increases an investor's shares. A stock split has key implications for shareholders. The benefits that a stock split generates, are it facilitates the management of financial portfolios and attracts fresh investors. Stock splits have more implications, including share prices changing after a stock split. Knowing what a stock split entails and related aspects are essential to make the most of your investment. 

For investors holding company stock, a stock split is an important activity that increases an investor's shares. A stock split has key implications for shareholders. The benefits that a stock split generates, are it facilitates the management of financial portfolios and attracts fresh investors. Stock splits have more implications, including share prices changing after a stock split. Knowing what a stock split entails and related aspects are essential to make the most of your investment. 

What is a stock split?

Typically, stock splits occur when companies want to make their stocks affordable to draw in more investors. When a company issues more shares to its present shareholders by way of reducing each share’s face value at a particular ratio, a stock split occurs. Essentially, this indicates that the quantity of outstanding shares grows due to the division of the shares originally issued. However, a rise in the quantity of shares does not mean that the said company’s market capitalisation or shareholder stakes change. 

Earlier it was mentioned that the stock split occurs within a particular ratio. For instance, if the ratio is 1:5, this translates to every shareholder getting 5 shares for a single share held presently. The table below illustrates an example of a pre-stock split scenario versus a post-stock split scenario (the ratio of the split is 1:5): 

It is important to note that when a stock split takes place, the face value of every share drops by the ratio of the stock split. 

What happens when a stock splits? 

In stock trading, stock splits play key roles in planning future investment decisions. When a company chooses to split its stock, the number of outstanding shares rises, but in terms of total value, the company remains as it was before the split. Furthermore, every shareholder’s stake remains unchanged. This is because the price of each share also undergoes a split (reduces). After a stock split, an investor may have more company stock but the value of the stock is the same as before. 

Additionally, after a stock split, the stock of the said company becomes more appealing to new investors as it makes investment affordable. This is because the price per share is reduced. Furthermore, the liquidity of the stock goes up as the quantity of outstanding shares has risen. Finally, investors search for upcoming stock splits of high-value stock as after the split, the stock becomes more affordable than it was before the split. Thus, such high-value stock which may have once been an intimidating investment prospect turns into an investment opportunity. 

How does a stock split affect you? 

If you already own company stock, a stock split may not be significant. However, it has its perks. For one thing, it makes your portfolio management hassle-free and gives you more liquidity as you have more shares to sell. 

In case you are not a company shareholder of the company that has split its stock, you can avail yourself an opportunity to purchase shares of a company that were once highly priced and now are more affordable, offering you an opportune time to invest. 

Why Companies Use Stock Splits and How a Stock Split Works 

Now that you have answered the question, “What is a stock split?”, you can explore why companies use stock splits and how they work. Essentially, a stock split is a corporate action when a company elects to raise the quantity of its outstanding shares. The main reason to do this is to make the company’s stock more affordable to new investors by increasing outstanding shares. Furthermore, some companies may split stock because shares are of a higher value than similar companies in the same sector. A stock split may increase the demand for a company stock that splits shares, as shares become affordable. Moreover, this action leads to the enhancement of a stock’s liquidity in the market, encouraging more purchases of stocks. 

Now for the working of a stock split. When a stock split occurs, the number of the company’s outstanding shares rises and the price for each share reduces in the same proportion. However, the value of the company and its market capitalisation remains unchanged. Additionally, investors should know that the most common stock splits occur in the ratios of 2:1 or 3:1. This means that for every share held before the stock split, an investor will receive 2 or 3 shares, respectively. 

Key Dates in a Stock Split 

Once you have grasped stock split meaning, you should know when stock splits occur. Here are the main dates:

• Record Date: This is the date when the said company checks its records for the identification of those shareholders eligible for a stock split.
• Ex-split Date: On this date, the stock begins to trade at the new split price.

Credits of new divided shares with new ISINs take place on the trading day following the record date. 

Types of Stock Splits 

Typically, a company is able to execute two kinds of stock splits, as explained below: 

• Regular Stock Splits: In a regular stock split, a company can take one of two actions to split the stock. The company may opt to increase the quantity of outstanding shares for present shareholders. Secondly, the company may want to increase the quantity of shares, expecting the share price to fall, while the valuation and market capitalisation remains unchanged.
• Reverse Stock Splits: In a reverse stock split, the company reduces the quantity of outstanding shares of which the value remains unchanged, but investors hold fewer shares than before.

Pros and Cons of Stock Splits 

If you are considering investment in any upcoming stock splits, you must think of the pros and cons, highlighted below: 

Pros

• Enhanced Liquidity: If any stock’s price increases in the market, there is a drop in trading the stock. However, when a company increases its quantity of outstanding shares at a reduced price for every share, there is a boost to market liquidity due to a decrease in the spread between ask and bid prices.
• Easy Portfolio Balancing: As the price of every share drops after stock splits, portfolio managers can sell stock and buy new stock in smaller portions.
• Put Options are Sold Cheaper: If a stock is highly priced, selling a put option on it proves a costly affair. As a stock split decreases share prices, buyers are willing to buy put option contracts at low prices.
• Increase in Stock Price: Initially, after a stock is split, its share price may drop. However, long-term stock prices of large-cap companies tend to increase, outpacing the market.

Cons

Stock splits have some disadvantages:

• Decrease in Share Price: Sometimes a stock split occurs when a company wishes to be delisted for some reason. 
• Increased Volatility: A stock split can potentially create market volatility when the new share value kicks in as more investors flock to invest.

An Example of a Stock Split 

A notable example of a stock split is when IRCTC split its stock. The share price was trading at ₹4,500. In October 2022, the stock split in the ratio of 1:5. The share price of IRCTC went to ₹900 post the stock split. New investors clamoured to invest in the now-affordable stock and existing investors could manage their portfolios better. 

Adjustment of Futures & Options Contracts Due to a Stock Split 

Futures and options contracts have underlying securities denoting their value. If the underlying security is a stock that has undergone a stock split, the strike price and the market lot for F&O contracts have to be revised by a calculation for the adjustment. This is termed the adjustment factor. So if a stock has split in the ratio of, say, A: B, the adjustment factor is calculated as B/A. Therefore, if the stock has split in a ratio equal to 1: 5, the adjustment factor will be 5/1 which is equal to 5. 

Now, in the world of stock trading, if a stock in a futures and options contract has split, a revised computation must be done. In case the futures/adjusted strike price is to be arrived at, the original futures/strike price will have to be divided by the adjustment factor. Furthermore, for the market lot, the adjusted revision is achieved by multiplying the original market lot by the adjustment factor. 

Conclusion 

While a stock split opens access to shares for many investors who otherwise may not have invested in a given company’s stock, it also means that the market capitalisation and the value of the company stay unchanged. A stock split generates a high level of liquidity in the market but investors must research any stock before investing.