What is a stock split and why companies do it?

What is a stock split and why companies do it?

What is a stock split and why companies do it?

A stock split is an increase in the number of outstanding shares in such a way that the proportionate equity of each shareholder remains the same.

So if a firm has a capital of Rs 10 crore, with 1 crore shares, each with a face value of Rs 10, and when this firm opts to split its shares into a face value of Rs 5, then it would issue 2 shares, against 1 share held by each shareholder.

The firm will now have two crore shares, with a face value of Rs 5, and its equity capital would be the same at Rs 10 crore.

What happens to the price?

Once a company decides to split its shares, it calls for a book closure. Post the book closure, the stock price falls to the same extent as the split.

So if the stock was trading at Rs 200, before the split, post the split, it would trade at Rs 100 per share. 

However, the market value, or market capitalisation, which is the number of shares multiplied by the market value of the stock, would not change and remain the same.

Why does a company split its stock and what approvals are needed?

One reason as to why stock splits are done is that a company’s share price has moved so high that it is difficult or expensive for people to buy in round lots.

So for example,

if ABC company’s shares were worth Rs 1,000 each, an investor would need Rs 1 lakh to invest in 100 shares. 

If, however, the company splits its share in the ratio of 10:1 and the price was Rs 100, you would need a mere Rs 10,000 to buy 100 of these shares.

Recently, HDFC has opted to split its shares in the ratio of 1:5. Also, Tata Tea has decided to split its shares into face value of Re 1 from the earlier face value of Rs 10.

Any stock split can be done only with the approval from the board of directors and shareholders. 

Once the approval is obtained, the company can call for a book closure and split its shares.

What is a reverse stock split?

A reverse stock split, or reverse split, is the opposite of a stock split,

i.e. a stock merge — a reduction in the number of shares and an accompanying increase in the share price.

There are many institutional investors and mutual funds, who have rules that forbid them from purchasing stocks which quote below Rs 10, as they feel the stock may be manipulated or belongs to the penny category. 

Every professional company management likes to have a broad-based shareholding.

Hence to attract such investors, a company could go for a reverse stock split, where the ratio is reversed namely 1-for-2, 1-for-5 and so on. 

However, some firms also use a reverse stock split as a tactic to reduce the number of shareholders or avoid getting delisted.

However, this is not as commonly used as stock splits. 

Earlier this year in March, LG Balakrishnan and Bros went in for a reverse split to consolidate the share’s face value from Re 1 to Rs 10.


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