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. 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 reduces the price per share.
• A reverse stock split reduces the number of shares and increases the price per share.
• Both leave the company’s market capitalisation and investors’ total holding value broadly unchanged initially.

What is a Stock Split?

In a stock split, a corporation divides its shares into more shares than before, increasing the total number of shares while lowering the price of each share. Despite investors owning more shares at lower prices, the total value of their capital remains about the same, since only the number of shares changes, not the amount invested by an investor.

Example: You own 100 shares at ₹1,000 each, for a total of ₹1,00,000.

After a 2-for-1 stock split, you have 200 shares at ₹500 each.

Your total investment value remains ₹1,00,000. 

How do Stock Splits Work?

A stock split is when a corporation divides its existing shares into more shares. When the number of shares increases, their price drops accordingly. However, the value of the investor’s portfolio stays almost constant. Generally, a stock split works as described below:

• A stock split is publicly announced.
• A stock split ratio is determined (for example, 2-for-1, 3-for-1, 5-for-1).
• Existing shares are split.
• The number of investments owned by investors is multiplied by the ratio.
• The share price is adjusted.
• The price per share decreases with the number of shares.
• The total value of shares remains approximately 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 lower share price can help attract more investors to the business.

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

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 lowers the share price, making it more affordable for 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 a stock's marketability because the reduced share price makes it more affordable for more investors to buy.
• Preserves Investment Value: Although the number of shares increases, the investment's value remains the same immediately 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, also called as stock consolidation, 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: You own 100 shares at ₹50 each, for a total of ₹5,000.

After a 1-for-5 reverse split, you have 20 shares at ₹250 each.

Your total investment remains ₹5,000, but you now hold fewer shares at a higher price. 

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 increase in the share price signals the company’s stability and financial strength, thereby improving market perception of the stock.
• Institutional investors: Institutional investors are sometimes reluctant to buy low-priced shares. Therefore, companies perform a reverse stock split to make their share price attractive to institutional investors.
• Eliminate the stigma of penny stocks: Penny stocks often carry stigma in the market, but a company can reduce it by increasing its share price through a reverse stock split.
• Decreased shares: A reverse stock split consolidates the number of shares. This means the number of shares is reduced, but the stock's market value remains the same.
• Fundraising: A higher share price makes it easier for the company to issue new shares and raise funds.

How Do Reverse Stock Splits Work?

A reverse stock split is an action taken by a corporation in which existing shares of its stock are combined into fewer shares. A reverse stock split occurs over a few simple steps:

• The company states the ratio: the number of shares that will be merged into one share. The most common ratios include 1-to-2, 1-to-5, and 1-to-10 ratios
• The shares merge: The number of shares owned by shareholders is reduced in the specified ratio.
• The share price rises: Fewer shares will represent the same value in terms of equity, thereby resulting in a change in the share price.
• The total value of the investment remains unchanged: the reverse stock split provides no additional value to shareholders. It only changes the number of shares and their prices respectively.

How does a Reverse Stock Split Affect Investors?

A reverse stock split does not immediately change the total value of an investor's holdings. 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 seen as a sign of financial weakness, which can undermine 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 rather than issue 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 Vs. Reverse Splits

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

Key Considerations for Investors

When 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 affect the business's intrinsic value. 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 red flags, since they are usually undertaken when companies have low share prices or financial problems.
• Investors should focus on the fundamentals of the business, such as sales growth, profits, debt, and cash flow, rather than 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 that modify the number of shares outstanding and share prices without affecting market capitalisation or the value of investments. Though stock splits might make it easier for individuals to invest in stocks, reverse stock splits might indicate problems in the company that warrant evaluation.