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Saturday, July 21, 2018

What is a Stock Split

Stock splits can be a confusing concept for those new to the stock market, but a failure to understand them can have a significant impact on your calculations of Intrinsic Values and therefore your decision making power to invest and fetch returns.

What is a Stock Split?
In a layman's terms, and as the name suggests, a Stock split is splitting of stocks and thereby increasing their numbers. It is a decision by a company's board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders. For example, in a 5:1 stock split, 4 additional shares are given for each share held by a shareholder. That is, 1 share become 5 shares now. So, if a company had 10 thousand shares outstanding before the split, it will have 50 thousand shares outstanding after a 5:1 split.

Does All Financial Data related to shares change after a Stock Split?
What changes with a Stock Split is the number of shares - nothing else. The total earnings, profit, dividends, the operations, the way of doing business, the management - nothing changes at all. So, what changes with a Stock Split is any financial ratio where the number of shares are involved in the calculations. The stock split is just technical in nature, and does not add any real value to the company. Let me give you two examples:

Example 1
As an example, EPS (Earnings per Share), in very simplistic terms, is the total earnings of a company divided by the number of outstanding shares. This will be a directly impacted financial ratio since the number of shares (denominator in EPS) have changed.

Example 2
If you understand how the current market price (CMP) of a share is calculated, you will appreciate that even CMP will change with a Stock Split. The CMP is calculated by dividing the total market capitalisation of the company by the total number of outstanding shares. A stock's Market price (also called as Current Market Price or CMP) is therefore affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased. In the example of a 5-for-1 split, the share price will be reduced in the ratio of 1:5 - since the number of shares have become 5 times. It is 8th standard mathematics - nothing more, nothing less.

What happens to the Market Capitalisation?
In a Stock Split in the ratio of 3-for-1, the number of outstanding shares in the market will triple. On the other hand, the price per share after the 3-for-1 stock split will be reduced by dividing the price by 3. This way, the company's overall value, measured by the market capitalization, would remain the same. Think of it as cutting a whole cake into slices. Instead of having one whole cake, you now have multiple slices of the same cake. The amount of cake you have, however, is the same before and after the split. This again, goes on to emphasise that there is no real value addition by a Stock Split.

Why Does Management go for Stocks Splits?
Why do companies go through the hassle and expense of a stock split? There are various reasons that management may find it lucrative to go for a Stock Split. 
Here are some of them:
1/ A 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. The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company has not changed. This has the practical effect of increasing the liquidity in the stock.
2/ While a split in theory should have no effect on a stock's price, it often results in renewed investor interest, which can have a positive impact on the stock price. While this effect can be temporary, the fact remains that stock splits by blue chip companies are a great way for the average investor to accumulate an increasing number of shares in these companies. Many of the best companies routinely exceed the price level at which they had previously split their stock, causing them to undergo a stock split yet again.
3/ When a stock splits, it can result in a share price increase following a decrease immediately after the split. Since many small investors think the stock is now more affordable and buy the stock, they end up boosting demand and drive up prices. Another reason for the price increase is that a stock split provides a signal to the market that the company's share price has been increasing and people assume this growth will continue in the future, and again, lift demand and prices. 
Remember that this is all a perception based investing by retail investors - which is why perceptions drive the market. A smart investor will calculate the intrinsic value based on the new number of outstanding shares.

What happens to the historic prices that were published?
Now, this is a tricky situation. If a stock has been trading at Rs. 100 before the split, and then undergoes a 1:2 split, then it would start trading at approx Rs. 50 immediately after the split. Anyone looking at the trend of stock price over a period of time, and not being aware of the stock split - may take it as a fall in stock price from Rs. 100 to Rs. 50. The investment decisions on seeing such a trend can be very different when you are not aware of a stock split. To avoid this confusion, usually, most financial portals would 'adjust' the historical stock prices of the stock so as to have a fair comparison with the current and future prices. So, if you ever thought that you bought a share for Rs. 100 in Mar 2018 and if you go back to that financial portal looking for a March 2018 price, you might as well find that the price of the stock in March 2018 was Rs. 50. Do not be surprised with this. This is natural, and logical, and as I keep saying, 8th standard mathematics.

How is it different from a bonus issue of shares?
A company announces a bonus issue when its cash reserves increase and it decides to convert the increased value into shares. Thus the shareholder gets a bonus share free of cost. While in a stock split only the number of shares increase, in a bonus issue the number of shares and share value both increase. It is sometimes also issued as an alternative to the dividend issued by the firms. Bonus share results in reduction of reserve capital which is used to create new shares. Stock split results in reduction of face value of stock. In both cases, market capitalisation remains the same. More on Bonus shares in our next post...

Some Practical Examples of Stock Splits
The Indian Stock Market undergoes abundant stock splits every year. As many as 53 companies listed on BSE went for stock splits during the financial year ended March 31, 2017. 
Read this : 
https://economictimes.indiatimes.com/markets/stocks/news/over-50-companies-split-shares-in-fy17-will-mrf-or-eicher-follow-suit-in-fy18/articleshow/58006595.cms

In fact, Stock Splits is a very common phenomenon. In India, every month, there are many companies undergoing a stock split. 
Have a look at some of the latest stock splits here:
https://www.moneycontrol.com/stocks/marketinfo/splits/index.php

Summary
Stock Splits is a regular phenomenon for companies. It helps them make their stocks more liquid. Being only technical in nature, stock split does not add any value to the market capitalisation of the company. It just reduced the face value of the stock and increase the number of Stocks in circulation. Having said that, its understanding is vital to calculating the correct Intrinsic Value of the stock. Though 8th std mathematics and common sense, many investors (not surprisingly) tend to get perturbed with it.

Regards

Manoj Arora
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