ata Motors and Bhel are heading for a stock split even as several companies have done so in the recent past. What happens when a stock splits? The most obvious fallout is the dilemma it lands the investors in. Should they remain invested in the stock? Should they buy it before or after the split? Are such company moves merely cosmetic actions or can they offer large gains to the investor? Let us consider why a company splits its stock, how the process works, its impact on the share value, and whether you stand to gain or lose from such a move.
A stock split is an action by which a company lowers the face value of its stocks, simultaneously increasing the number of outstanding shares, but keeping the company's total capital base intact. Suppose that the face value of an XYZ company's share is Rs 10 and the outstanding shares that have been issued are 10,000.
If XYZ declares a 2:1 stock split, it means that its shareholders will own two shares for every one held by them previously, but at half the face value. So the company's outstanding shares will double to 20,000, while the face value per share will halve to Rs 5.
So if you owned 50 shares worth Rs 500 before the split, you will now have 100 shares worth Rs 500 after the split. This split ratio may vary for different companies. So while one may go for a 3:1 split, another company may opt for a 5:1 or 4:3 split.
The day that the split is carried out is known as the record date. Only those shareholders whose names appear on the company's records on this date are eligible for the additional shares. Subsequently, the shares start trading at the new price on the stock exchanges.
As is obvious from the above example, the split does not affect the value of your holdings. It is similar to splitting a Rs 10 note into two notes of Rs 5 each. Similarly, the company's fundamentals don't change, with its earnings and equity capital base remaining the same.
So why does the company go for a stock split? It does so in order to make the shares more affordable for a larger group of investors and, thereby, stimulate enhanced trading in the scrip. A stock split is a play on the psyche of the investor. When a share's price runs up too high, smaller investors find it difficult to buy it.
To make it attractive for such people, the company carries out the split, which brings down the share price. So, while some investors may be unwilling to pay Rs 1,000 for a certain stock, they may be more inclined to buy it at Rs 250, following a 4:1 split.
Such a move is thus initiated when there is a huge spike in the share price. When shares are trading at abnormal prices, it also affects the scrip's trading volumes on the exchange. By splitting the shares and increasing the outstanding shares available for trading, the company can ensure better liquidity.
Does a stock split affect you? Some investors believe that such a move has no impact as it is a mere accounting procedure and that it doesn't affect the share's intrinsic value. This is true at the exact moment that the stock is split, but the price movement it triggers before and after the split date (even the announcement date) can interest investors.
The most widely accepted view is that a stock split results in a spike in the share price as the demand for the shares increases after the move. There is enough evidence to prove that trading activity usually improves after a split (see table).
We considered eight Nifty stocks that have witnessed a split in the past three years. Take Bharti Airtel, which split the face value of its stock from Rs 10 to Rs 5 in a 2:1 split on 24 July 2009.
This sent its stock price spiralling from around Rs 800 before the split to Rs 400 after the move. This made a sizeable impact on the scrip's volume on the NSE, with average daily traded volume rising 153% in the month after the split, compared with that in the previous month.
Consequently, the average daily turnover rose 26%, while the average trades per day rose by 58%. But what about its share price? On the day of the split, it surged by 3.2%, while the Sens*x rose by 1.2%.
This means that the stock value, instead of falling by half, actually fell by a lesser amount as more investors bought the stock at the cheaper price. In fact, as can be seen from the table, this has been true in all but one instance; the stock has outperformed the broader index by an average 2.1% on the split date itself.
"Although stock splits seem to be purely cosmetic measures, there exists ample empirical evidence that these are associated with abnormal returns on both the announcement and the execution days, bringing a change in the shareholders' holding value," state Bangalore-based professors Suresha B and Gajendra Naidu in a May 2011 report published in the International Journal of Research in Commerce and Management.
They conducted an empirical study on the subject, which included all companies among the constituents of CNX IT that opted for a stock split between 1999 and 2009. It found that on the split date and on days close to the move, there was a positive average abnormal return, but it did not persist after the actual split date.
Does this mean that investors should look forward to the announcement of a stock split? Not necessarily, as there is no uniformity in the price movement that accompanies stock splits.
Some stocks witness a sharp rise in their prices before the split date (Sun Pharma, M&M), while others do so after it has happened (HDFC, Kotak Mahindra). Then there are stocks that even drop in value after the split (ONGC, Sesa Goa).
Given this inconsistency, investors should not be concerned about a stock split announcement. Instead, they should focus on the fundamentals of the company and its growth prospects.
If the company is doing well, its shares will also benefit. If you are not already a shareholder, you can always buy its shares at a lower price after the split.
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