What is the Stock Split? Reasons and They Matter?

Overview

Companies can decide to increase the number of outstanding shares while simultaneously decreasing the nominal share price proportionately.

A stock split is a corporate procedure that increases or decreases a corporate’s total number of shares outstanding without changing the firm’s market value or the proportionate ownership interest of existing shareholders.

The total value of the shares remains the same compared to the pre-split amount although the number of shares outstanding increases by a specific multiple.

The new share price corresponds to the number of shares, the value of the shareholder’s stock doesn’t change, and there is no change in the company’s market capitalization.

Companies execute a stock split to reduce the individual share price. The stock split requires advance approval from the company’s board of directors.

Before announcing a stock split, a company’s board of directors must decide on a distribution rate.

  • A stock split is a step taken by companies in which a company divides its existing shares into multiple shares to improve the liquidity of the shares.
  • The stock split does not add any real value.
  • The share prices automatically adjust in the stock market when the company implements the action of a stock split.
  • The stock split does not change the equity capital of the company and its net assets.

Reasons for Stock Split

The main reason companies decide on a stock split is to increase the liquidity of the shares in the stock market.

More liquidity makes the buying and selling the shares easier for the customer. The split may be in the form of a ratio or percentage according to the shareholder’s convenience.

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Liquidity is important because it is the degree of flexibility with which investors can purchase or sell the shares without impacting the share price.

Besides making the share price more attractive to individual investors, there are a few more reasons a company might split its stock.

If a stock’s price rises per share, it reduces the stock’s trading volume. Increasing the remaining shares at a lower share price helps in liquidity.

Portfolio managers may find it convenient to sell shares to buy new ones when each share price is lower. Selling a put option may cause more costs for stocks trading at a high price.

Another important reason for a company to split its stock is that it tends to boost share prices.  

Investors may be worried about whether they can buy stocks with a high value, but a wider variety of stocks at a reduced rate per share makes investors feel pleasant buying the stock.

Thereby, companies with a higher price may go for a stock split and reduce the share rate, attracting prospective investors.

Why do Stock Splits matter?

A stock split means the company is dividing its shares so that if the investor has one share now, he owns two. It would not impact the overall quantity but increase the number of shares.

For this reason, the number of shares increases, leaving the investment amount as it is. The actual reason is that if the share price is too high, it will create complexities for the small investors to buy that shares.

If stocks are split into two, then the price of the shares will also reduce by two, allowing small investors to invest in the market and big investors to sell their holdings easily.

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Another benefit is that since there is more demand for that shares, in the future if a company needs money, it can issue shares to the public and more people will apply for them.

Certainly, most companies prefer to keep their share prices at a much more affordable level to make their stock accessible to as many investors as possible.

If share prices fall too far, the firm might also be de-listed from whatever exchange it is traded on. Troubled companies stuck in this position will sometimes employ a reverse stock split.

Reverse Stock Split

A reverse stock split is a process whereby a company reduces the number of shares outstanding. The reverse stock split does not affect the net equity capital either.

The total shares will have the same market value after the reverse stock split. The reverse split may be used when a company is short of cash.