What are stock splits?

Stock splits are corporate undertakings that involve the division of a company’s existing  stock into more shares.  A stock split increases the number of the company’s outstanding shares by dividing each share, which in turn decreases stock price.  The stock’s market capitalization however, remains the same.

Being a purely paper transaction, a stock split doesn’t change the capital structure of the firm, nor does it change the asset side of the balance sheet except to the extent that splitting requires real resources for accounting, legal and paperwork costs, plus continuing increased listing fees required by stock exchanges for listing shares.

Effects on shares and market capitalization

Assume, for example, stock ABC is trading at Ushs 400 and has 100 million shares issued and thus a market capitalization of Ushs 40 billion.  The company decides to implement a 2-for-1 stock split.  Each share owned by the shareholders is therefore divided into two new shares giving a total of 200 million shares of stock ABC.

Because the stock price is subsequently halved, the market capitalization stays the same but it now has a different breakdown:  number of shares listed is 200 million, multiplied by the new price of Ushs200 gives a capitalization of Ushs40 billion.  The true value of the company has not changed.

All publicly quoted companies have more authorized shares than listed shares trading at the stock exchange.  A stock split is a decision by the company’s board of directors to increase the number of shares that are listed by issuing more shares to current shareholders.

Effect on Price

The stock price of a stock is also affected by a stock split.  One share represents the value of the company’s underlying assets plus its growth potential divided by the number of outstanding shares.  After a stock split, only the value of the denominator changes in the equation.  After a split, the stock price will be reduced since the number of shares that are outstanding increased.

The new stock price is determined by multiplying the previous stock price by the inverted split ratio.  In this case 2-for-1 inverted becomes 1/2 ; this multiplied by the stock price and the new trading price of Ushs 20.

A stock split is usually done by companies that have seen their share price increase to levels that are either too high or are beyond the price levels of similar companies in their industry.  The primary motive is to make shares seem to be more affordable to small investors even though the underlying value of the company has not changed.

A stock split usually results in a share price increase since the stock looks affordable and investors go buying the stock.  Another reason for the price increase is that a stock split provides a signal to the market that the company’s share price has been increasing and people assume that this growth will continue in the future.

Reverse Split

One different version of a stock split is the “reverse” split.  This procedure is typically used by stocks with low share prices that would like to increase their share prices to either gain more respectability in the market or  to prevent the company from being de-listed from the stock exchange.  In a reverse 5-for-1 split, 10 million outstanding shares at Ushs 50 each would be changed to only two million shares outstanding at Ushs 250 each.  In both cases, the company is still worth the same Ushs 500 million.

For example, a 1:2 reverse split means you get half as many shares, but at twice the price.

It is usually a bad sign if a company is forced to reverse split.  Firms do it to make their stock “look” more valuable, but in reality nothing changes.  A company may also do a reverse split to avoid being de-listed.

Why do a Stock Split

Stock Splits are ways in which a firm can lower or raise the price of its stock by adjusting the number of shares belonging to each shareholder.

The underlying reason for a stock split is to price the stock in a trading range that enhances its marketability.  The transaction involves an adjustment in the number of outstanding shares of stock and the stock’s par value.  Splitting the stock brings the share price down to a more attractive level.

The actual value of the stock does not change one bit, but the lower stock price may affect the way the stock is perceived and therefore entice new investors.  Splitting the stock also gives existing shareholders the feeling that they suddenly have more shares than they did before.

Most splits seek to increase in a stock’s liquidity, which increases with the stock’s number of outstanding shares.

The objective of splitting to enhance market liquidity is closely linked to other asserted motives.  For example, a popular explanation of splitting, to move a company’s stock into a popular price range, is to widen the shareholder base, which is assumed to increase a stock’s liquidity.  Clearly, the actual nominal price of a stock is a matter of indifference to a company unless there are consequences in terms of the number and amount of shareholdings.  The number of analysts following a stock, will increase the amount of trading in the stock, and thereby improve the liquidity of that stock.  The last observation, however, reflects back again to the desirability of liquidity.

This article originally featured in the Uganda Securities Exchange Quarterly Bulletin.