The Relevance of Stock Splits

1. What is a stock split?

A stock split occurs when a company increases the number of its stock shares outstanding without increasing shareholders’ equity.

In simple terms this is what happens when a stock split occurs:

Say you own 50 shares of HDFC bank and each share is worth 2000 rupees today. The amount of money that you have invested in HDFC bank is therefore equal to 50 x 2000= Rs. 1,00,000.

If HDFC bank decides to split its shares 4-for-1, this is what happens. Each share is split into 4 shares. Since you have 50 shares and each share is split into 4, you will now have 200 shares.Since each share was worth Rs. 2000 before the split, now each share is worth Rs. 2000/4; i.e Rs. 500. The amount of money that you have invested in HDFC bank is therefore equal to 200 x 500= Rs. 1,00,000.

Yes, your account is still worth the same, not more.

2. Why do companies then split their shares?

Companies split their stock to make it affordable to more investors. Many people would shy away from a Rs. 2000 stock but would consider a Rs. 500 one.You are getting the same amount of ownership in the company for each rupee you invest. It is just a psychological thing.

3. If there is no mathematical difference, is their relevance to stock splits?

Yes, it is relevant for the following reasons:

  • They are often a sign of good things to come.A company usually won’t split its stock unless it’s optimistic about the future.
  • A stock split drops the price of the stock.Lower prices tend to move quicker than higher prices. Also,the fluctuations of a lower priced stock have a greater percentage impact on return than they do against higher priced stocks. A Rs. 2 increase is a 4 percent gain for a Rs. 50 stock, but only a 2 percent gain for a Rs.100 stock.

So although mathematically irrelevant, stock prices are psychologically and financially relevant although the evidence for higher long-term returns is mixed.

 

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