Stock splits: Reason and implication

B. Venkatesh

RUPANGI Impex is considering a stock split. It refers to the reduction in the face value of the share. Rupangi, for instance, proposes to reduce the face value of its stock from Rs 10 to Rs 2. And these are becoming more and more frequent as many companies resort to it than to bonus offers.

Why do companies engage in a stock split? And what are its implications? A company typically splits its stock when its market price is very high. It does so to make the stock more affordable to the retail investors.

Suppose you have, say, 10 shares of Company X whose market price is Rs 200 each and face value is Rs 10. What happens if Company X splits its Rs 10 share into five shares with a face value of Rs 2? The market value of the share will fall, providing opportunity for the retail investors to buy the stock.

If it is pure math, Company X's stock should fall to Rs 40 (Rs 200/5). But, more often than not, the stock will remain at a somewhat higher level. For instance, Company X's stock may fall to Rs 60 and not Rs 40. Why? The demand for the stock increases as it now becomes more affordable to the retail investors. The increased demand pushes the stock to higher price levels.

Now, this may seem like twisted logic. It is like a restaurant charging you more for one chappathi cut into 2 pieces than for the one offered as a whole. But the stock market seems to welcome the idea. Why?

The reason is that a stock split is often considered a signal from the management that the company is likely to perform well in the future. This, perhaps, is the reason why split stocks have been found to provide higher returns -- even over a three-year period -- than other stocks.

But a stock split increases your trading costs. How? Suppose Company X's stock trades at Rs 200-201, meaning you can sell at Rs 200 and buy at Rs 201. The split stock may probably trade at Rs 60-60.50. Notice that the bid-offer spread does not reduce proportionately to reflect the stock split. This increases your transaction cost. This, in short, are the implications of and the reason for stock splits.