How Stock Splits Affect Your Investment

It divides the value of all of the outstanding shares of a company and the most direct objective is to boost the liquidity of the shares and reduce the trading price.

Another corporate action (an action taken by the management of an organization) that can affect the investors of the company is a stock split. As the name implies, it involves dividing a company’s stock or existing shares into multiple shares.

It divides the value of all of the outstanding shares of a company and the most direct objective is to boost the liquidity of the shares and reduce the trading price. Examples of stock splits are: 2 for 1, 3 for 1, 10 for 1, or as the company wishes.

An example of a stock split is when current investors receive 2 shares for every share they have, each now worth half of the price of the original share price before it as split.

The investor would now own two for one of his or her shares in the company. However, the market capitalization remains the same.

Market capitalization is computed by multiplying total number of outstanding shares by the price the share is trading at. Hence, if a company currently has 10 million outstanding shares being sold as N100/share, it means the current market capitalization is 1 billion Naira.

Following our example, if the share is split into two (that is, 2 for 1), the number of shares would double and 20 million shares would be in circulation with the price now trading at N50.

The market capitalization is still 1 billion (20 million shares multiplied by N50/ share.)

In other words, the split does not add any real value. In other words, it increases the number of shares the investor has but not the value – at least not immediately.

Same goes for the company itself as the equity in Naira for the company does not increase; it simply increases the number of outstanding shares in circulation.

Being that the price has now been split in half and is consequently sold at a much lower price, the market would demand more of the company’s shares and the price would adjust upwards accordingly.

When this happens, the existing shareholders would benefit from it and new buyers would demand it some more. As you would probably tell, this action is typically taken when the stock price is too high, thus making it too expensive for new investors to purchase.

Also, by virtue of the increased liquidity, investors now have an increased degree of flexibility such that investors can buy and sell shares in the company without making too much of an impact on the share price of the stock. Many studies have also shown that stocks would usually outperform the market immediately after a split occurs.

A stock split might drive the price of each individual stock higher but this too has its risks. For one, any careful investor should naturally worry about whether the company invested in is now creating too many shares.

However, it doesn’t change so much of what exists before the split. There are also cases where there is a reverse split which is really just the opposite transaction where the company divides, as opposed to multiplying the available number of shares. It would also proportionately increase the share price.

Written by Lawretta Egba.