What is Stock Split?
Stock split, as the name suggests, is splitting of shares, which increases the number of shares of a company. As the company is not increasing its capital but splitting the existing shares, the market capitalization remains the same. So, in order to keep market capitalization the same, the price per share goes down. For example, a 2-for-1 splitting means that, if an investor holds 100 shares of Company X worth Rs.1,000 each, he/she now owns 200 shares of Company X worth Rs.500 each.
Why do companies decide to split stocks?
Stock split reduces the price per share of a company while increasing the number of shares. As a result, stock splits, enhances liquidity in the market by not only making the shares more affordable but also through the increase in supply. In addition to liquidity, stock split also gives a company a psychological advantage through decrease in share price. Granted that the one unit of share is now worth half the ownership than before, most investors will still show more excitement about the price decline than the value decline. So, while the split, in theory, is not supposed to affect the price of a stock, the excitement, given the fall in price, can have a positive impact of the price of a share. A study by Grinblatt, Masulis and Titman presents evidence which indicates that stock prices, on average, react positively to stock dividend and stock split announcements that are uncontaminated by other contemporaneous firm-specific announcements. Stock Split, however, doesn’t affect the business model, the profitability, or the success of the business.
How does the market react?
Technically, stock splitting provides no immediate or natural benefit to the shareholder. It has only doubled the number of shares they hold and proportionally reduced the par value of each share held. Still, it’s worth analyzing how the market reacts to stock splits despite of their seemingly neutral and arithmetic nature. It is a tried and tested fact that stock splitting tends to create a short-term overreaction due to the perception of lower prices for each unit of a stock. Furthermore, stock splits are carried out by companies with higher share price, which could be the result of growth or future prospects. And as such, the split can be regarded as a positive indicator and the price of the share may go up. However, that is not necessarily the case as studies like the one by Millar and Fielitz, have found that stock prices are not significantly affected by new stock distributions per se regardless of the market conditions.