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How Does a Split Ratio Work

31 May 2023

What is a Stock Split?

  • The term 'stock split' refers to a situation where a company increases the number of its outstanding shares to increase the liquidity of the stock.
  • This process has no impact on the company’s market capitalization because the price of each share splits up as well.
  • Stock splits lower the price of the share, making it more affordable without a loss of value.
  • Some of the most common split ratios are 3-for-1 and 2-for-1. 

How Does the Stock Split Process Work?

  • The shareholders receive additional shares in the case of a stock split, which increases the total by a specified ratio based on the shares they held earlier.
  • In a stock split, companies make their shares more affordable to the public at large. This enhances the liquidity of the shares in the market. 
  • For example, a single share of MRF is priced at Rs. 96,685. Not many people can afford to even buy a single share of this company. This shows why stock splits are carried out for a company.
  • Let us remember that stock splits are value-neutral, i.e., they do not add value to any enterprise. This is because the number of shares goes up by multiples, and the price per share is reduced proportionately.
  • The shares of companies thus become tradeable in the long run because the tradeable range is achieved by the stock. 

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What Are the Advantages of Stock Splits?

Stock splits have various advantages, such as:

  • Stock splits improve liquidity because the stock comes into a very tradeable range.
  • Since the stocks are very affordable after the split, they are very easy to sell and churn.
  • Since the option premium is reduced after the stock split, it appears that the risk of an option is reduced.
  • In most cases, stock splits prove profitable for a company over time.

What Are the Disadvantages of Stock Splits?

Stock splits have various disadvantages, such as:

  • The process of stock splits is expensive, and not all companies can bear the cost of no movement in capitalization.
  • Since the stock split does not add any value to the company's financial position, it might not always be the best option. 
  • Regulatory compliance with stock splits can be overwhelming for companies at times.

An Example of a Stock Split

Let us understand the concept of a stock split with an example:

Particulars

Pre-Stock Split

Post-Stock Split

The ratio of a stock split is 10:2

The old face value is Rs. 10

The new face value is Rs 2

Number of outstanding shares 

5 crores

25 crores

Total net profit

Rs. 55 crores

Rs. 55 crores

Earnings per share

Rs. 11 

Rs. 2.2

Price-to-earnings ratio

25

25

The intrinsic value of a share

Rs. 275

Rs. 55

Stock price

Rs. 280

Rs. 60

Market capitalisation

Rs. 1400 crores

Rs. 1500 crores

 

  • Considering the above example, if you are a shareholder, your shareholding is up five times, but the price is down by one-fifth. The impact is marginal in this case, and that's why stock splits are known to be value-neutral. However, when the high-priced stock is split, the shares become more valuable as they gain a wider reach.
  • Companies go for stock splits to gain a wider reach and greater acceptability. This not only helps them get more recognition but also ensures that stocks will be bought in the future as well.
  • However, the stock split process is a tedious one, and not every company can afford to carry it out. The stock split ratio boosts the public's attention towards shares at large. 
  • Generally, for the par value of Rs. ten, a ratio of (in Rs.) five, three, two. or one is maintained.

Conclusion

  • To sum up, the process of stock splits involves rigorous work on the part of the company that issues the shares.
  • The basic reason for performing a stock split is to maximise outreach to the public at large.
  • Once the public buys shares, the company has achieved its target of recognition.
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