Understanding Stock Splits and Valuation
Author: Denny B Justin
Stock splits are a corporate action that increases the number of a company’s outstanding shares while reducing the price per share proportionally. Essentially, a stock split involves breaking down existing shares into smaller denominations. Stock splits often create a perception of affordability and stability, which can attract retail investors. Lower share prices can make stocks seem more accessible and less risky, increasing interest and potentially more buying activity. The reduced share price often conveys a sense of affordability and stability, attracting retail investors.
Stock splits are a common corporate instrument that can significantly impact investors’ perceptions and market dynamics. Common stock splits are typically expressed as a ratio, such as 2:1, 3:1, or 5:1. For example, in a 2:1 stock split, if you initially held 100 shares of a company’s stock priced at ₹1000 per share, after the split, you would own 200 shares priced at ₹500 per share. The total market capitalization remains unchanged. Dividend payments or EPS are not affected by the stock split. If a company paid a particular dividend per share before the split, it continues to pay the same amount after the split. Similarly, EPS remains unaffected because earnings and the number of shares increase proportionally.
One of the primary reasons companies opt for stock splits is to make their shares more accessible to a broader range of investors. By reducing the share price, they aim to attract retail investors who may find the stock more affordable and it will boost demand. Moreover, the increased number of shares often enhances liquidity in the stock, resulting in narrower bid-ask spreads and smoother trading.
They also have drawbacks. Stock splits can inadvertently lead to misinterpretation and overvaluation. Some investors perceive lower-priced shares as inherently cheaper, overlooking that the company’s fundamental value remains unchanged. This misperception can cause stocks to become overvalued, potentially leading to speculative bubbles that may burst, causing significant market corrections. Eastman Kodak and Polaroid, iconic names in the photography industry, succumbed to their inability to adapt to the digital age despite engaging in multiple stock splits to boost investor interest. Polaroid filed for bankruptcy in 2001, and Kodak followed the suit in 2012. In both cases, stock splits were not the primary cause of these companies’ decline. Instead, their inability to pivot and innovate in rapidly evolving industries played a more significant role. However, the repeated use of stock splits to boost stock prices artificially may have contributed to investors’ misperceptions about the companies’ true worth.
In conclusion, stock splits are tactical moves to enhance accessibility and market perception, without bearing on a company’s intrinsic value. Investors must grasp that stock splits are essentially cosmetic adjustments to share quantities and prices. Sound investment decisions should be grounded in comprehensive research of a company’s fundamentals and financial health. The cases of Eastman Kodak and Polaroid serve as cautionary tales, reminding us that stock splits. At the same time, a tactical tool, cannot substitute for a company’s ability to adapt, innovate, and thrive in dynamic markets. While stock splits may influence investor sentiment, understanding their essence empowers investors to navigate the financial landscape with clarity and confidence.
