The agency theory says that business managers are agents for the shareholders of the company. The prime duty of the agents is to maximize the shareholders’ wealth.
The company management or BOD precisely formulates the strategic plan for the company. Listed companies have a limited number of shares outstanding and for trading in the stock market, for several reasons, the BOD may decide to increase the number of shares trading in the stock market.
An IPO or second IPO is used for issuing new shares, a rights issue or bonus shares are other forms where the total number of shares will increase for the company.
In a stock split, though, the company increases the number of outstanding shares, brings down the share price but keeps the total market capitalization the same.
So what’s in it for a shareholder if the total market cap remains the same? The shareholders will keep the same net value at least at the time of the stock split.
The management often uses the stock split practice to increase the shares trading and liquidity. Once the split ratio is announced; till the date of transaction the share prices often see a little boost mainly due to a positive signaling effect.
On the transaction date, after the stock split transaction, the share prices change to adjust for the new total number of outstanding shares.
Mathematically, a shareholder is not affected by the transaction since the stock split keeps the same proportion of new shares. For equity shareholders:
- As the total market capitalization remains the same, the shareholders net worth remains unchanged
- The proportion of shareholding does not dilute with the new split stocks addition
- Do not lose any money due to stock split transaction
- There are no tax implications as there are no new shares in issue practically
- The long term gains depend on the risk volatility
Historically a company decides for a stock split when the share prices reach a certain high level where retail investors find it difficult to trade.
A high share price is an obvious indicator of a company’s strong financial health. In that scenario, the investors need not worry about future gains in the post-stock split scenario. A high valued, stable share price indicates a less volatile and high performing stock, that trend likely continues after the stock split too.
However, if the company performs a reverse split and tries to consolidate the falling share prices it can adversely affect the stocks in the long run too.
In either reverse split or a forward stock split, theoretically, the shareholders’ net wealth remains unchanged at the transaction date.
Dig deeper and the true reason for the stock split may tell the future scenario. A strong stock with a high price, post-split is likely to keep the strength, while a low priced stock due to company performance or market conditions is more often likely to go down the drain.
Investors making money with short-selling, often try to take advantage of the low share prices on the stock split transaction day, but newer stricter regulations now attach covenants that forbid shareholders from selling the extra shares for a specific time.
A large number of outstanding shares, subsequently, will make it difficult for the company to keep the EPS, P/E, and Dividend yield ratios consistently.
Blue-chip firms aside, many firms after a stock split would find it hard to pay the same dividend ratio to the shareholders, which they often shun and opt for the bonus share issues.
Shareholders do hold the option for selling extra (bonus) shares to compensate for the lost dividend. In a stock split though, the shareholders need to wait for the share price to rise to a point where they can capitalize on the extra shares by selling out.
In conclusion, as far as the shareholders’ net worth on the transaction date of the stock split is concerned, there is no loss or gain for the shareholders. However, in a reverse split, the share prices often keep falling that can result in a loss of share value for the shareholders.
In a forward stock split, the volatility attached to share price is seen for a short period. A forward stock split brings valued gains to the shareholders’ in the long run as the signaling effects are positive.