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Tutorials on stock splits

What is a stock split?

When a company splits its stock, it means that it will issue additional shares to the existing investors by reducing the face value of a stock. For example, if a stock has a face value of Rs 10, a two-for-one stock split will mean that there will be twice the number of shares as before with a face value of Rs 5 each for the new share. So if an investor owns 100 shares, he will have 200 shares after the split. In case of a five-for-one split, there will be five times the number of shares and the investor will own 500 shares for every 100 shares.

How is it different from a bonus?

A stock split is similar to a bonus as both increase the number of shares. But there are a few differences in terms of accounting. A bonus reduces a company's reserves, converts it into equity capital and then issues additional shares from it. In absolute rupee terms, the equity capital (number of share multiplied by the face value) rises after a bonus. After a 1:1 bonus, the equity capital will double.

In a split, the absolute rupee capital is maintained at the same level and the reserves remain as before.

What does a stock split change?

While the bonus changes a few items on the liabilities side of the balance sheet, the stock split changes only the face value of the share and the number of outstanding shares.

The earnings per share reduce in both cases as there are more outstanding shares, but the value of the investment, the price-earnings ratio and the market capitalisation remain the same as the stock price gets corrected. So if a share is trading at Rs 5000 before a two-for-one split, it will trade at Rs 2,500 after the split.

What are the merits of a stock split?

When stock prices are very high, companies feel the need to reduce the stock price so that a wider investor base can find the shares affordable. Buying Zee Telefilms after its five-for-one at Rs 700 is considered more affordable than buying it at its pre-split price of Rs 3500.

It also has an impact on the liquidity. Zee's average trading volumes have risen 7.8 times while the outstanding shares have gone up five times after its five-for-one split.

A stock split has very little impact for the shareholder from the academic viewpoint as it changes nothing in real terms. It's like cutting an 8-inch pizza into 12 slices from four slices before. This is more so, especially after dematerialisation of shares where it is possible to buy one share of a company.

While most managements like to issue splits, there are some who don't like it as it doesn't change anything. Legendary investor Warren Buffett of Berkshire Hathaway doesn't find any sense in a stock split and has never issued a split though the share trades at $ 54,000 each! Back home, MRF doesn't issue a bonus despite having the financials on the balance sheet.

But investors love stock splits and bonuses. Empirical studies in the US do suggest that stock splits improve prices in most cases as investor sentiment improves. Bonus issues in India have also provided returns to investors.

But analysts do feel that both bonus and stock split indicate the management's conviction to sustain a higher profit growth to service the higher number of shares.

Who is eligible for a stock split?

The company announces the split ratio and the record date. All shareholders whose names appear on the books as on the record date will be eligible for the additional shares. A few weeks later, the shares will start trading ex-split on the stock exchanges.

Tutorials

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