Stock Split: Meaning, How It Works, Advantages & Disadvantages

In recent years, online share trading has become a popular way to invest. One key concept that investors should understand in online share trading is a stock split. In a stock split, a company decides to give its existing shareholders more shares by reducing the value of each share. This means that there will be more shares available, but the overall value of the company and the value of each shareholder's share remain the same.

Moreover, companies split their stocks to make trading prices lower and increase liquidity. During a split, a company can determine a specific ratio, such as 1:2 or 1:5, which indicates how many new shares shareholders will receive for each share they own. In this article, let's explore how stock splits work, their impact, and advantages and disadvantages.

What is Stock Split?

The stock split is when a company gives its current shareholders more shares by making each share worth less. It means there will be more shares available, but the company's value and the value of each shareholder's share stay the same.

For example, the company decides on a specific ratio. Let's say the ratio is 1:5, it means that for every one share a shareholder has, they will receive five shares instead.

Here are illustrations for different ratios of change in shares, share price, and share face value before and after splits.

 Before Split:

After Split:

How does Stock Split work?

Companies split their stocks by issuing additional shares to shareholders, increasing the total shares by a specified ratio based on existing shares. Often companies split their stock to lower the trading price and increase liquidity for investors.

Moreover, it is up to the board of directors to decide what ratio should be used to split a company's stock. They can split stock in a 2-for-1, 3-for-1, 5-for-1, 10-for-1, or 100-for-1. For example, in a 3-for-1 split, investors will receive three shares for every one they hold.

After a 3-for-1  split, the old share price will be divided by 3 to reduce the price per share. It's because a share split doesn't affect a company's market value.

How does a stock split affect you?

A stock split may not appear to impact existing shareholders, but as the number of shares increases, portfolio management becomes easier and liquidity is improved. In case you're not a shareholder of the company that did a share split, you can buy shares now at a lower price.

For example, if ABC company's stock price was Rs. 4500. After a share split in the ratio of 1:5, the share price of ABC company would become Rs. 900. Thus, making it affordable for you and giving the flexibility to manage portfolios.

Advantages of Stock Split

If a company's stock price rises too high, it can be tough for regular investors to buy 100 shares, since it gets too expensive. Thus, by splitting the stock, the company makes it more affordable for people to buy. In addition, when a company has more shares available, it's easier for people to buy and sell them.

Even though a share split shouldn't affect stock value, it often gets investors interested in the company. Sometimes, this increased interest causes the stock price to go up. In some cases, companies split their stock to show their confidence in their future growth and to give investors a positive feeling.

Disadvantages of Stock Split

Splitting stock isn't always a good thing for a company. While keeping the company's value the same, a stock split can be expensive and involve a lot of legal work. Also, share splits don't really change a company's value. It's like cutting a tasteless cake into smaller slices—it doesn't make it taste better. In the same way, a share split doesn't add value to the company.

Additionally, there are some people who don't support share splits because they think it could attract the wrong investors. Even though share splits have benefits, they're also expensive and don't change a company's value fundamentally. Also, it's possible for some companies not to split their shares to keep their investors exclusive.

Conclusion

The stock split occurs when a company gives existing shareholders more shares, reducing the value of each share while maintaining the overall value of the company. During a split, the company determines a specific ratio, such as 1:5, where shareholders receive five shares for every one they own. With this adjustment, investors are able to buy more shares at lower trading prices, thus enhancing liquidity.

Investors can benefit from share splits since they make shares more affordable and generate interest in the company, potentially boosting stock prices. In addition, there are some disadvantages. A share split can be costly, involve legal complications, and do not fundamentally change the value of a company.