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When a company takes the decision to increase the number of its outstanding shares there takes place what is commonly known as a stock split. In this, the company splits the stock, whereby the shareholder would get two shares of the same value which is equally divided in face value. The split in stocks can take the form of 2 for 1 or 3 for 1 or even 5 for 1, depending on the company.
Splitting of the stocks or stock split is a common action taken by corporates that want to increase the number of outstanding shares. This is done by issuing more shares to the existing shareholders. In the case of a 3 for 1 stock split, the shareholder will get three shares for every share held by him. In simple terms, if there were 10,000 outstanding shares prior to the split, there will now be 30,000 shares. The market capitalization of the company will remain the same, which means that the price of the shares will have reduced.
A company may have various reasons for splitting their stocks but one of the most common reasons is the increase in liquidity. Increase in liquidity makes way for more buyers and sellers to trade in their stocks. It may so happen that the shares of a company may be too high for many investors to buy and a further rise in price may discourage them from participating; to make the shares accessible for all, companies reduce the cost per share by splitting the stock.
With a stock split, the number of shares in the company increases but the market capitalization of the company remains unchanged. The change in market capitalization takes place when new shares are issued which increases the total market capitalization of the company. This reduces the existing shareholder’s value. A stock split does in no way dilute the value of the existing shares.
Example:Consider a company that has 1000 outstanding shares of INR 10 face value and there was an announcement of a split of INR 5 per share. Now, the same share of INR 10 face value will become 2 shares of INR 5 face value. If you are holding 100 shares of this company, you will now have 200 shares of the same company after a stock split.
When a stock split of 2 for 1 happens, you as a stockholder will have two shares for every one share you own, without having to incur any extra cost. This does not mean that the value of your holding has increased but it does make it easier for you to carry out your trading transactions. It is particularly beneficial for retail investors who can acquire a large number of blue chip company shares which otherwise would have been very expensive.
In most cases, it is seen that a stock split tends to result in the appreciation of the stock price. This is because as the stock now appears to be cheaper, there is a higher demand for it from small and retail investors which leads to a rise in the price. On a psychological level too it creates a positive approach towards investing in such companies as the stock price that earlier seemed very high becomes available at a good price.
Another step companies take with regards to stocks is the reverse stock split. In this instance, the company reduces the total number of outstanding shares by a multiple and thereby increases the share price of the stock by that very multiple. The market capitalization of the company remains the same with the changes in the value of the shares. If you owned 10 shares of INR 200 each and the company decided to have a reverse stock split of one for two, you will end up with 5 shares of INR 400 per share.
It is very similar to when someone pays you two INR 200 rupee notes in exchange for four INR 100 rupee notes. You end up with two notes instead of one but the value remains the same.
One of the prime reasons for a reverse stock split is for the company to increase the price of its shares. Sometimes a company’s stocks may be trading at a very low price which may give the impression that it might be a penny stock; In order to change this image, promoters may want to announce reverse stock splits
As an investor you will not face any increased liability or reduction in your taxation liability owing to either stock splits or stock merge; this is because at the split or the change thereafter does not change the value of your overall holding.
Investing in shares subjects you to market risk and therefore one must take financial counsel before doing so. To choose from some of the best stocks in the market, visit ClearTax where we have handpicked funds and plans to meet your risk profile and financial needs.