Google announced their stock split.
And then now, Amazon has announced their stock split as well.
Immediately after the stock split announcement, the share price climbed up to 10%.
Why does stock market get excited about a stock split announcement and shoots the stock price up?
What advantage does it have for this share price rise? We will dig deeper into that topic in this episode.
Hi. My name is Vijay Mohan. You are watching - Investment Insights.
What is stock split? Let us take a look at it thru an example.
The example we are going to use is "Mannar and Company" (a fictional company).
Mannar and Company's business is - that does not matter. We don't care.
The value of this Mannar & Company as of Today is Rs. 1 Crore (10 Millions).
This value 1 Crore is split into 10 shares. So value of 1 share is Rs. 10 Lakhs (1 million).
So 1 Crore company. 10 shares. Value of one share is 10 lakhs.
Out of these 10 shares, we own one of the share as our investment.
Now Mannar and Company is deciding to split their shares by 1:2 ratio. What does that mean?
Each share is going to be split into two. One cut. Two pieces.
So what happens when we cut the 10 shares of the company? They becomes 20 shares.
What would be the value of each share now? That would have been cut into half as well. It would have come from 10 lakhs to 5 lakhs.
What happens to that one share we own? That would have become 2 shares.
Our shares total value is still same 10 lakhs. But now we have 2 shares instead of 1 and each share's value is 5 lakhs.
So is there any profit for us from this share split?
If an apple is taken from us and returned to us as two halves, does that change the total value of apple?
It is still same as one whole apple (value wise).
We are not going to get anything extra. Same is true in Stock split as well. We don't have any additional gain
OK. We don't have any profit from this stock split. Does the company at least get any additional profits?
This is a company of value 1 Crore. By splitting the 10 shares, only the share holders see the change. But there is no change in the business.
That is, there will not be any change in the revenue or the profit of the company from this stock split.
If there is no profit for us or for the company, then why all these companies are announcing stock splits?
There are other reasons for stock split.
Now in our Mannar and Company, if there are only 10 shares, then how many maximum share holders can exist? Only 10 can exist.
Now if the company goes thru 1:2 stock split, then it can have a maximum of 20 share holders.
That means, many more people are getting chance to invest in this company. That is one advantage.
If the number of shares in a company doubles up, then what happens to the number of traded shares in the market?
The number of shares that get exchanged among buyers and sellers in the market will definitely go up.
If the traded volume goes up, the price difference between buy and sell we reviewed in last episode will go down.
That means, we can buy that company's share for a better price.
Just because it is a better price, do not assume that it is going to be in 1000's. It will be very small in the range of 5 to 10 paise. But still, it is an advantage.
Now Amazon has announced a 20 to 1 stock split.
That means, each share is going to be split into 20 shares.
So its share price will go down by 1/20.
If the share price of Amazon is $3,000 before the day of split, then on the day of split, the price will come down to $150.
We would have hesitated to buy this stock at a price of $3000 in the past.
But if we see the same Amazon stock for a price of $150, we do not hesitate to buy immediately as it is cheaper now.
But do we realize that we are getting only 1/20th of the share now? May be.
But who cares about that logic? We will be happy to buy the stock now for a cheaper price $150.
Psychologically convincing people like this to buy their company shares is another reason for stock split.
Next - options contracts. Each option contracts comes as a bundle of 100 shares.
Let's say that an option contract price is 10% of share price. If Amazon's share price is $3,000 then 10% of 3000 is $300.
If each contract has 100 shares, then the price of that contract is 300*100 = $30,000.
There will not be many people to buy a contract for $30,000.
But after 20 to 1 stock split, we will be able to buy the same contract for $1500.
The value of the contract is 1/20the of the original one. But still, there will be many in the market to buy that contract now for $1500.
That will lead to increase in trading volume. This is also a big advantage with stock split.
We will cover the options topic more in detail in another episode.
So from a stock split, though there is no direct advantages for stock holders or for the company, there are indirect advantages like these.
That is why when the share price goes up by a lot, companies announce a stock split to bring down the share price.
Stock price goes up by 5 to 10% after the stock split announcement for these same advantages.
We do have to pay a premium price for these indirect advantages right? That is the reason for the price increase.
We were reviewing conventional stock split all this time. There is a reverse stock split as well.
If one share is split into multiples in a conventional split, many shares are grouped into one in a reverse split.
Now in our Mannar and Company, if there is a 2:1 reverse split, then 10 shares will become 5 shares.
The value of each share would have doubled to 20 lakhs from 10 lakhs.
Usually when a company's stock price is beaten down a lot, then the company announces reverse split.
They don't want to give the impression of penny stocks by trading at a lower share price. That is why they do a reverse split and artificially increase the share price. All illusion.
Now we understand stock splits. How does a bonus shares work? It works the same way as well.
If one share is split into two in a stock split, here with bonus shares, they say, you can keep your original share safe. But we will give you another share as a bonus. That is all the difference.
In both the cases, number of shares will increase and the price of the share decreases.
"You highlighted the difference first. But now you are confusing us by saying that they are one and the same". True.
Let's see how Mannar and Company handles this bonus shares.
Value of the company: 1 crore. Number of shares: 10. Value of each share: 10 lakhs.
Now in a 1:2 stock split, 10 shares will become 20 shares.
The price of the share will come down to 5 lakhs from 10 lakhs.
But instead if the company has announced bonus shares, then even in that case, 10 shares would have become 20.
Share price would have come down by half to 5 lakhs as well.
So regardless of whether it is a stock split or a bonus shares, it is no different for shareholders like us.
But it is reported differently in company's accounting.
Do we need to know that accounting difference? Not really. Why do we have to confuse ourselves with more terminology unnecessarily. We can leave that as an optional question.
So in short, stock split or bonus shares is not going to give any direct advantages for shareholders or for the company.
But there are indirect advantages like lower share price and more trading volume. That is all there to know about Stock Split.
We will soon meet again in another episode. Thank you.