Splitting hair over stock splits

Investors must have read a lot on stock splits in newspapers of late. The last bull run had seen many stock splits. Not to mention spiralling stock prices due to stock splits. Ever wondered what does a stock split actually do?

In theory, a stock split shouldn't affect market capitalisation

Let us take the stock split of XYZ as an example. The company split its share into two. If the pre-split price of a share is Rs10 and the stock is split two for one, then theoretically speaking, the price of the new (split) share should be Rs5. That's because the company's net assets do not increase, only the amount of its outstanding shares goes up. But life is vastly more complicated than theory. In the XYZ stock split, the market was expecting five shares for one; the two-for-one ratio disappointed it and the stock plummeted after the split was declared.

Theoretically, a stock split is a non-event. The fraction of the company that each share represents is reduced, but each stockholder is given enough shares so that his or her total fraction of the company owned, remains the same. The split should not change market capitalisation.

But it often improves sentiment for the stock

In practice, however, market capitalisation does change after a split. A split often drives the new price per share up, as more of the investing public is attracted by the lower price. A company might split when it feels its share's price has risen beyond what an individual investor is willing to pay, especially when the shares are bought and sold in marketable lots. Even when the shares are traded in the demat mode, where even one share may be traded, the price may be high enough to discourage small investors.

It attracts small investors and increases liquidity

Another reason frequently offered for a stock split is that it increases liquidity. Because the number of shares increases, the amount that investors are willing to buy or sell also goes up. For instance, an investor may be willing to buy one share of Rs. 200, but may not venture if the share price is Rs. 1,000. Companies sometimes want to attract individuals to stabilise the price, as institutional investors buy and sell more often than individuals. That's yet another reason for a split.

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