Definition
All publicly-traded companies have a set number of shares that are outstanding on the stock market. Stocks split when the board of directors for a given company decides that it would be in the best interest of their company to split that company's stocks. The board of directors can split the stock in any manner they see fit. They can mandate that each share of outstanding stock be split into two shares, three shares, even more. If they decide, for example, to split the stock "two-for-one," it means that every outstanding share of stock in the company is now split into two outstanding sharesA corporation whose stock price is really good in the share market could very well use the option of splitting its shares. This action results in issuing supplementary shares to existing shareholders.
Why companies opt it…
When a company does well, the demand for its stock grows and the price of that stock rises. Eventually, however, if the stock price gets too high, small investors will perceive the stock as too expensive to buy. In order to combat this, companies with high stock prices may split their stock, thereby cutting the price of each share effectively in half. Often times, however, because splitting stock is a sign of prosperity and financial soundness, a stock's price will rise significantly after it is splitted
A stock split is a decision by the company's board of directors to increase the number of shares that are outstanding by issuing more shares to current shareholders .A few reasons are as follow:-
- First, as a stock price skyrockets, some people will be psychologically unwilling to pay that "high price" so a stock split brings the shares down to a more "attractive" level. Again, the intrinsic value has NOT changed, but the psychological effects may help the stock.
- Second, a stock split generally occurs in the face of new highs for the stock. Thus, it's an event dripping with positive connotations and associations. . . it's makes bulls snort and roar to suddenly have "twice as many shares" as they started with,.
- Third, and final, with lower-priced shares, a stock's LIQUIDITY increases, often reducing the BID/ASK SPREAD and making it easier to trade. This is always good.
Features
1. Although the number of outstanding shares and the stock price change, the market capitalization remains constant.
2. 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.
3. The primary motive is to make shares seem more affordable to small investors even though the underlying value of the company has not changed. A stock's price is also affected by a stock split. After a split, the stock price will be reduced since the number of shares outstanding has increased.
4. Stock splits help make shares more affordable to small investors and provides greater marketability and liquidity in the market
Types of stock splits
- Forward stock splits :- The term forward stock split is defined as when any company will announce a stock split, the price of the stock will decrease; however, the number of shares will increase proportion
- Reverse stock splits :- Reverse stock splits are less likely to be used by the companies as they show somewhat of a negative investment strategy attached to them. The reverse stock split is defined as the stock split under which a firm’s number of shares outstanding is reduced. If the price of a stock for a certain company drops too low, many mutual funds will not purchase them. Therefore, by having the low prices for their stocks, they run the risk of being delisted, or even being removed from the market indexe
Advantages
- The most important reason for a company to use this stock market strategy is to increase liquidity of the stock.
- This tactic is employed by many companies when their stock sales come to a standstill because of the consistent increase in the prices of their stocks.
- The low stock prices of a company would create a psychological stigma as buyers and sellers view them as worthless. By doing a reverse stock split, companies can raise the stock price by lowering the number of outstanding shares; therefore, eliminating the problems caused by the low stock prices.
- The transaction costs to the shareholders would be less after the reverse stock split. Secondly, the liquidity and marketability of a company’s stock might be improved when its price is raised to the popular trading range. Finally, Stocks selling at certain price below a certain level are not considered respectable which means that the investors underestimate these companies earnings, cash flow, growth, and stability
Limitations
- you can't get around the fact that a stock split has no affect on the fundamental value of the stock and therefore poses no real advantage to investor
- Critics would say that this strategy is by no means a time-tested one and questionably successful at best. Factoring in Commissions also take part when we discuss about advantages and disadvantages of stock splits
- This isn't such an advantage today because most brokers offer a flat fee for commissions, so you pay the same amount whether you buy 10 shares or 1,000 sharres.
- A stock split should not be the deciding factor that would attract you into buying a stock. While there are some psychological reasons why companies will split their stock, the split doesn't change any of the business fundamentals. In the end, whether you have two $50 bills or one $100 bill, you have the same amount in the bank as far as the stock split is concerned.
Conclusion
Stock splits have historically been used by the companies to increase or lower the number of outstanding shares and to change their company’s negative impressions of the stock price. Investment timing in companies like these has shown to be more psychological than realistic since stock prices are only adjusted in a way that the market capitalization remains constant. Stock splits are another interesting feature of investing and a good piece of knowledge for those who are learning about the stock market. The most important thing to know about stock splits is that there is no effect on the worth (as measured by market capitalization) of the company.
