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How Does a Split Ratio Work

stock market
Published Date: 30 May 2023Updated Date: 31 May 20236 mins readBy MOFSL
SPLIT RATIO

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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Disclaimer: The stocks, companies, or financial instruments mentioned in this blog are for informational purposes only and should not be considered as investment recommendations. It is advised to consult with your financial advisor before making any investment decisions. Investment in securities markets are subject to market risks, read all the related documents carefully before investing. Investors are strongly encouraged to carefully read the risk disclosure documents prior to participating in market-related investments or trading activities. Due to the volatile nature of financial markets, no guarantees can be made regarding investment returns. Motilal Oswal Financial Services Ltd. does not offer any assured returns on market-linked securities. Please note that past performance of stocks or indices is not indicative of future results.
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