What are Stock Splits & Stock Merge ? How do They Work?

When a company adjusts the number of its outstanding shares, it may undertake a stock split or a reverse stock split, also known as a stock merger. These actions change the number of shares and their per-share price without altering the company’s overall market capitalisation or the value of an investor’s holdings. Below, we explain what stock splits and mergers are, why companies pursue them, and how they impact investors.

Key Highlights:

• A stock split increases the number of shares and decreases the price of the shares without altering the company’s net worth.
• A reverse stock split decreases the number of shares and increases the price of the shares without affecting the company’s net worth.
• Both increase or decrease the number of shares and the price of the shares proportionately but do not alter the market capitalisation of the company or the value of the investors’ investment immediately.

What is a Stock Split?

A stock split is a method of corporate restructuring during which a company increases its number of outstanding shares by splitting its existing shares into numerous shares. Although the number of shares increases, there is no change in the total value of the investment.

Example: You have 100 shares of a particular company whose current share price is ₹1,000.

Your total investment is: 100 × ₹1,000 = ₹1,00,000

After that, the company announces a 2-for-1 stock split. 

Now you have 100 shares = 200 shares, Price of a share reduces from ₹1,000 to ₹500

The value of your investment is now: 200 × ₹500 = ₹1,00,000

So even though the number of shares has increased twofold, the total value of the investments remains the same.

Why do Companies Split Their Stocks?

The purpose of stock splitting by companies is to reduce the price of their shares without affecting the overall market value of the business organisation. A reduced share price can help in attracting more investors in the business.

• To reduce the cost of shares: Helps in reducing the cost of the stock, thus making it available to more retail investors.
• Increasing liquidity: An increased number of shares may help in boosting the volume of trading activities in the market.
• To attract more investors: A reduced share price can encourage participation by individual investors.
• Broadening the shareholder base: A larger number of investors will be able to hold the shares after stock splitting.
• Stimulating market interest: A stock split is often seen as a sign of strong company performance and growth in its operations.

Example: A business firm's stock is available at ₹5,000 per share. It declares a 5-for-1 stock split, which reduces the cost of the stock to ₹1,000. The company increases the number of shares by five times.

How Does a Stock Split Benefit Investors?

A stock split will not directly increase an investor’s wealth, but it provides certain benefits to shareholders. The stock split achieves this by reducing the share price and increasing the number of shares outstanding, thus improving the stock's liquidity and marketability.

• Accessibility: A stock split causes the share price to fall, which makes it more affordable to many retail investors.
• Liquidity: An increase in the number of shareholders willing to buy and sell the stock at a given price increases the stock's liquidity.
• Marketability: A stock split increases the stock's marketability since the reduced share price allows more investors to buy the stock.
• Preserves Investment Value: Although the number of shares increases, the value of the investment remains the same right after the split.
• Improves Market Outlook: The market interprets a stock split as a positive indicator that the firm’s management is optimistic about prospects and the business's growth potential.
• Investment Options: After a stock split, an investor can choose to buy more shares of the stock since they have become cheaper.

What is a Reverse Stock Split?

A reverse stock split is also called a stock split or stock consolidation and is a corporate event in which a company combines several equity shares into one. With fewer shares available, the market price rises accordingly, even though the company's market capitalisation and the value of investors’ holdings remain unchanged. 

Example: If you have 100 shares of a stock and the price per share is ₹50, then your total investment is: 100 × ₹50 = ₹5,000

The company now announces a reverse stock split in which 1 stock will be merged into 5. 

So, if you have 100 stocks, you will now have only 20 stocks.

Also, the price of each stock will be increased to ₹250 to account for the merger.

After the stock split: 20 × ₹250 = ₹5,000 

So, even right after the merger has taken place, the total value of your investment remains the same even if you have fewer shares at a higher price per share of the stock.

Why Do Companies Pursue Reverse Stock Splits?

A reverse stock split helps the company satisfy exchange listing requirements. In other words, it helps keep a stock's share price from falling below the minimum price required by a stock exchange.

• Enhanced market perception: An increased share price signifies the company’s stability and financial strength, which enhances the perception of the stock in the market.
• Institutional investors: Institutional investors are sometimes reluctant to buy shares that have a low price. Therefore, companies perform a reverse stock split to make their share price attractive to institutional investors.
• Eliminate the stigma of penny stocks: Penny stocks usually carry a stigma in the market, but a company can eliminate this by increasing its share price through a reverse stock split.
• Decreased shares: A reverse stock split consolidates the number of shares. This means that the number of shares is reduced, but the market value of the stock remains the same.
• Fundraising: A higher share price makes it easier for the company to issue new shares and raise funds.

How does a Reverse Stock Split Affect Investors?

A reverse stock split does not change the total value of an investor's holdings immediately. It reduces the number of shares while increasing the share price in the same proportion. However, it can have several practical implications for investors.

• Investment value remains unchanged: The total value of your investment stays the same immediately after the reverse stock split.
• Higher share price: The share price increases while the number of shares decreases in the same proportion.
• Negative market sentiment: Reverse stock splits are often viewed as a sign of financial weakness, which may affect investor confidence.
• Reduced liquidity: Fewer outstanding shares can lower trading volume, making the stock less liquid.
• Fractional shares: If the reverse split creates fractional shares, brokers typically cash them out instead of issuing partial shares.
• No guarantee of future gains: A reverse stock split does not improve the company's fundamentals or ensure future stock price growth.

Stock Splits, Reverse Splits and Taxation

A stock split or a reverse split does not affect the market value of the firm or the total value of the investor’s holdings immediately. Likewise, such repartitions do not result in any tax consequences at the moment of their realisation. 

Key Considerations for Investors

In deciding whether to invest in a stock following a stock split or reverse stock split, it is important to note that these corporate actions do not impact the intrinsic value of the business. Rather, investors should consider the company's fundamentals.

• Stock splits are usually taken positively because they make shares more affordable and liquid; however, stock splits do not add any value to your investment.
• Reverse stock splits should raise some red flags since they are usually taken when companies have low share prices or have financial problems.
• Investors should pay attention to the fundamentals of the business, such as sales growth, profits, debt, and cash flow, instead of focusing on splits.
• The purpose of the stock split should be analysed to see whether it will help grow the business or is taken to satisfy listing requirements.
• Decisions should not be made based on a company's stock split alone, as the fundamentals of the business will determine the future return.

Conclusion

Stock splits and reverse stock splits are corporate decisions aimed at modifying the number of shares and share prices without influencing market capitalisation or the value of investments made. Though stock splits might make it easier for individuals to invest in stocks, reverse stock splits might indicate problems in the company that need to be evaluated.