Stock Splits and Reverse Splits: Explained
Flabia Maharjan
What is a Stock Split?
As the terms clearly state, a stock split refers to when a single stock gets divided into multiple shares. This way, the number of outstanding shares increases, and the price of one share decreases. The most common stock split is two-for-one, which means that an investor who held one share pre-split now holds two shares of the same total value. To understand the concept of ‘Stock Splits’, let us look at this example.
A. Example
| Outstanding shares | Stock price (Rs) | Total value of shares (Rs) | |
| Pre-Split | 1,00,000 | 500 | 5,00,00,000 |
| Post-Split | 2,00,000 | 250 | 5,00,00,000 |
Let us take a hypothetical company ABC Ltd that has issued a total of 1,00,000 shares with a par value of Rs 100 per share. Then, it declares a stock split in the ratio 2-for-1 when the stock price is quite high at Rs 500 per share. After the split, shares outstanding will total 2,00,000, with a par value of Rs 50 per share, and available at a price of Rs 250 per share. As mentioned earlier, we notice an increase in the number of shares outstanding and a decrease in stock price. The total value of the shares pre-split (100,000 shares X Rs 500 per share = Rs 5,00,00,000) and post-split (200,000 shares X Rs 250 per share = Rs 5,00,00,000) remains the same since stock split does not add real value.
B. Reasons for Stock Splits: Liquidity & Affordability
Stock prices of companies can rise quite high, making it difficult for investors even to afford a standard lot of 100 shares. The main reason companies opt for stock splits is to lower the trading price of their stock to a range affordable to most investors, which contributes to increasing the liquidity of the shares. Increased liquidity makes buying and selling shares easier due to affordable stock price options obtained through a higher number of outstanding shares. Traders can buy and sell stocks quickly at any time within the market hours. The stock split gives an opportunity to average investors to acquire the stocks of blue-chip companies, available at a reduced price after the split, and accumulate increasing numbers of shares of such good companies.
A stock split does not supposedly result in stock price changes. However, it could attract a lot of investors towards the stock of a particular company that causes the stock price to rise, although for a short time.
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C. Impact on Individual Investor
A stock split does not change the total value of the investors’ investment. If an investor held ten shares of ABC Company’s stock, priced at Rs 500 per share then, his/her investment totals Rs 5000 (10 shares X Rs 500 per share). After the stock split in the ratio 2 for 1, his/her investment would remain the same, i.e., Rs 5000 ( 20 shares X Rs 250 per share). The changes that the investor would observe are an increase in the number of shares he/she holds to 20 shares and a decrease in the price of each share to Rs 250 per share. If ABC Ltd plans to pay a dividend of Rs 10 per share, then the dividend amount will also be reduced by the stock split ratio. In this case, the investor would receive Rs 5 per share as a dividend after the split. Although an investor cannot benefit from increased value, increased interest of investors towards lower stock prices can increase the market demand driving the stock price upward.
What is a Reverse Split?
A reverse split or a reverse stock split is the exact opposite of a stock split. It is the process by which a company merges its stocks to form a smaller pool of more valuable stocks. It increases the price per share by decreasing the total number of shares outstanding.
A. Example
Hypothetical company XYZ Ltd declares a reverse one-for-three stock split.
| Outstanding shares | Stock price (Rs) | Total value of shares(Rs) | |
| Pre-split | 300,000 | 100 | 3,00,00,000 |
| Post-split | 100,000 | 300 | 3,00,00,000
|
Here, total outstanding shares of XYZ Ltd is 300,000 available at Rs 100 per share in the market. It means the total market capitalization of XYZ Ltd is Rs 3,00,00,000 before the split. After the reverse stock split in the ratio 1:3, the total number of shares outstanding will decrease to 100,000, and the stock price will increase with respect to the reverse split ratio. Thus, the price increases from Rs 100 to Rs 300 post-split. However, the total market capitalization remains the same at Rs 3,00,00,000 even after the split since a reverse stock split does not affect the company’s value.
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B. Reasons for Reverse Split
1. Boost Stock Price
Low stock prices tend to decrease an investor’s confidence towards a particular stock, creating a deficiency of market demand necessary to drive the stock price upward. The most common reason companies declare a reverse stock split is to boost the stock price by reducing the number of shares outstanding.
2. Prevent Delisting
The risk of having to delist a company from the stock exchange (For e.g., NEPSE) is high when the value of its stock is extremely low and where minimum share price rules are present. In order to prevent delisting, companies declare reverse stock splits. It is a measure to increase a company’s stock prices by decreasing the number of outstanding shares.
3. Recover Company’s Image
The demand for stocks trading in single digits is inversely related to investor confidence. If a company’s stock constantly performs poorly in the stock exchange, then a reverse split leads to increased stock prices which helps recover a company’s image to a certain extent. It gives the impression that the company is doing well and thus, helps maintain its brand image.
4. Grab the Attention of Market Analysts
Higher-priced stocks pique the interest of market analysts, and a favorable opinion from an analyst is good promotion for the company. They are also more likely to get the attention of large institutional investors and mutual funds, many of which have regulations prohibiting them from investing in stocks with a price below a certain threshold.
C. Impact on an Individual Investor
Similar to a stock split, a reverse split does not have any effect on the investors’ total value of investment. If an investor holds 300 shares of XYZ Company worth Rs 100 each, then the total value of his/her investment accounts to Rs 30,000 (300 shares X Rs 100 per share).
Let us suppose that XYZ Ltd opts for a reverse stock split in the ratio 1:3. In a reverse one-for-three stock split, an investor receives one share for every three stocks he/she held before the split. The total number of shares he owns is 100 worth Rs 300 each due to the reverse split. The total investment value is still the same, i.e., Rs 30,000 (100 shares X Rs 300 per share) since the number of shares reduced has been balanced by an increase in the stock price. However, fluctuations in the trading prices post-split may put the investors at a loss/profit. If XYZ Ltd plans to pay a dividend of Rs 1 per share, then the dividend amount will increase by the reverse stock split ratio. In this case, the investor would receive Rs 3 per share as a dividend after the split.
Conclusion
Hence, stock splits and reverse stock splits are measures a company uses to control its outstanding shares and stock prices. While a stock split decreases stock prices by increasing the shares outstanding, a reverse stock split does the opposite. Investors react positively to stock splits because the stocks become affordable to most of the investors. One could observe a handsome benefit if the stock price were to rise due to greater market demand. If a company can achieve better earnings, improve its operations, etc., alongside going for a reverse stock split, it can potentially maintain the increased stock price and push it higher.
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