All Confusion About a Stock Split Cleared in 5 Minutes: Is It Good for the Company? Is it Profitable for Investors?

Thu, Jan 21, 2021 2:25 PM on Stock Market, Exclusive, Recommended,

The upcoming AGM of Nepal Life Insurance Company Limited (NLIC) will endorse a 2-for-1 stock split. While a stock-split is common practice internationally, this news of NLIC proposing a stock split has left investors confused.

If there is one thing that is constant in the investment world, it is that learning never stops. All the nooks and crannies of stock-split will be explained in this article.

What exactly is a stock split?

A stock split increases the number of shares of a company. However, in order to keep the total market capitalization the same, the price of each share is reduced.

The company is not increasing its capital in any way. It is just dividing the already existing shares into cheaper shares. For instance, in a 2-for-1 stock split, every share is divided into two shares. These two shares will have half the par value of the initial share. 

NLIC has also proposed a 2-for-1 stock split. If this is approved and if you have 10 shares of NLIC, you will get additional 10 shares from NLIC. You will then have a total of 20 shares. However, the par value of each share will be Rs. 50, not the Rs. 100 that is at present. 

The stock price of NLIC is very high compared to the par value of Rs. 100. However, after the stock split, NEPSE will set the opening price at half the stock price of the company. The price of the company after then is completely in the hands of the investors. 

So, basically, you divide the existing shares into cheaper shares. Why do companies choose to split their stock?

The reason is pretty simple. Let us consider we have iron weights of 20 kilos. However, our iron weights can not be carried by people who can only carry 10 kilos each.

In that case, a logical solution will be to split the weights in half so that we get iron weights weighing 10 kilos each. That way, we can get the work done in a way so that nobody feels the weight is too heavy. Also, more number of "weight-carriers" is actually beneficial, at least in the stock market (explained later).

A stock split makes the stock more liquid

A stock split also does what it was primarily intended to do: attract small investors. Companies, investors, and the exchanges all love a fair distribution of ownership in a company. This ensures that the company's stock is not prone to price cornering and manipulation.

Splitting existing shares into cheaper shares means there will be more shares in the market. This makes it easier for investors to buy or sell the shares. In financial terms, this increases the stock's liquidity. If a stock is more liquid, it is generally believed that the share price gives a more accurate picture of the company's valuation.

For example, if the shares of a company were to trade only once a year, investors would have to wait one whole year to value a company and project its more accurate picture. However, if the stock trades daily in huge volume, any change in company fundamentals or investor sentiment will be reflected immediately. Ideally, we want the stock price to reflect the company's performance at that instant without any delay in valuation.  

So is a stock split good or bad for the company? 

Splitting the existing shares into more shares does not do anything for the company. Behind every stock is a company that does business. The ideal investment strategy is to find out what business that company does and how good it does it.

Splitting the existing shares will not change how the company does business. It will not change the motivation or the efficiency of the employees. A stock split will not give the company more customers, sales, or revenue.

Thus, in theory, you will only have more shares of the company at a cheaper price, while the company does its business as usual. 

Nonetheless, a stock split can put the company at a psychological advantage

Companies with cheaper share prices have no reason to split their shares. If a company decides to split its shares, it means that the company is growing, which is reflected in the growing share price. It also signals that the company is optimistic that the price will grow in the future.

Even though the intrinsic value of the stock has not changed, many investors buy after the split because they feel they are getting a lower price, and this tends to drive the price of the post-split stock higher.

Wrapping Up

A stock-split is a comparatively new term in the Nepalese securities market. Investors are debating with each other about whether a stock split is beneficial for the company, the investors, and the overall health of the securities market. 

While a stock split theoretically has no effect on company performance and valuation, investors love to be bullish or bearish about a stock split. Having varied opinions in the stock market is okay, in fact, it is appreciated. Bulls buy and bears sell, and this is how a free market governed by supply-demand works.