In business, liquidity is often a greater challenge than achieving profitability. For listed corporations it might be an even bigger headache, the most widely quoted answer to why companies opt for the stock split is to increase the liquidity.
There are several other reasons for a listed company opting for stock splits, and as to what are the implications of this decision on all stakeholders.
A stock split is simply an increase in the number of shares outstanding. For example, if a listed company has 1 million shares outstanding, and announces a stock split, the total number of shares will increase depending on the decided ratio.
A stock split may take two forms; a forward stock split and a reverse stock split. In general, a stock split is often termed a forward stock split in which the listed company increases the outstanding shares, so we’ll take on the topic from here on about forwarding stock split.
How Does It Happen?
A company may decide any ratio for a stock split e.g. a 2 for 1, 3 for 1, 5 for 1, etc. Simply, a 2 for 1 split means if the previous number of shares were 1 million it will now be 2 million, and so on.
All shareholders keep their new number of shares in the ratio decided, so their voting rights do not get affected.
Also for the company as a whole, once the stock split happens the share price falls but the total market value or capitalization does not change.
Prime Reasons for a Stock Split:
So if the market cap doesn’t change, who do companies opt for it?
- An increased number of shares brings the share price down; the company can control the market share price without any bad signaling effect.
- A stock split brings the share prices down which makes it more convenient for common investors to buy the shares.
- In the long-term, the share prices tend to increase generally which helps stabilize the market value of the shares.
- A lowered share price attracts more investors and hence enables the company to sell more shares and capitalize on liquid cash.
- A stock split may happen to satisfy existing shareholders if the company is short of cash and instead of dividends the management may announce bonus shares in the form of a stock split.
In stock markets, a higher share price for a company means a successful company but often blue-chip firms reach a point where the share price is deemed too high.
That red flag makes it difficult for common investors to buy the shares as for large firms the number of outstanding shares is in billions.
The stock prices get affected by any news about the company, either performance-related or strategic decisions from the BOD.
When the management confidently decides on a stock split, it also gives a positive signal to the investors about the management’s confidence in future company endeavors.
Also as the total market capitalization doesn’t get affected, so the decision doesn’t make the shareholders unhappy about it.
Either way, cash liquidity is the prime reason for most of the stock split decisions either for investment purposes or as a replacement for dividend cash.
Real-World Example:
Since its inception and listing publically with an IPO in 1980, the tech giant Apple Inc. has been through 4 stock splits. 03 of them were a 2-for-1 stock split, while the latest one was in 2014, which was a 7-for-1.
Before the stock split, the share price for Apple reached a staggering $690 mark, and a 7 for 1 split meant the share price adjusted to $92.
For Equity Shareholders, the net effect of a stock split remains largely neutral, as it doesn’t affect their shareholding position, EPS, or Dividend payout ratio.
For day traders, often short selling or trading with Futures and options, the stock split also doesn’t affect adversely, as with the short-selling their number of increased shares will compensate for the reduced share price.
Importantly for common stockholders, the tax implications of the stock split are also neutral, as there is no excessive cash payout.
The only drawback is the caveat (if attached) that new split stocks cannot be sold for a specific time period.
Large firms may have to opt for a stock split more than once, as controlling the share price is very important.
From day traders to equity investors, a forward stock split presents no negative impact on their investments.
In the long term, however, the company reaps the reward of increased cash liquidity and frequent share trading.
