What would be your reply in a situation where you have a 100$ bill to pay and someone offered you two bills of 50$ each to pay replacing the original one. Would you accept that offer? This might sound a pointless exercise to some of you but analogy of stock splitting is same. Let’s take a deep look on stock splitting to understand what stock splitting means, why it is done and what it means to investors.
What is Stock Splitting?
Stocks splitting can be understood as a corporate action that increases the number of outstanding shares for a corporation by dividing each share and which indirectly diminishes its prices. However, stock’s market capitalization remains same just like when dividing the 100$ bill into two parts does not change the overall bill to pay. Some of the most common stock splits are 2-for-1, 3-for-2 and 3-for-1.
Let’s take an example, suppose stock A is currently trading at $40 and company has 10 million shares issued. Simply means company is having market capitalization of $400 million ($40 x 10 million shares). Now further, if company decides to implement a 2-for-1 stock split then for each share owned shareholders will receive one additional share, deposited directly into their brokerage account. They will be having now 2 shares for each 1 previously held, but twist is that the price of the stock will also be reduced by 50%, from $40 to $20. You can notice that the market capitalization remains the same – as it has doubled the amount of stocks outstanding to 20 million while in chorus reducing the stock price also by 50% to $20 for a capitalization of $400 million. The true value of the company hasn’t changed at all. This is stock splitting.
In an easy way if you want to determine the new stock prices after splitting, divide the stock price by the splitting ratio. Also there is another term i.e. Reverse Stock Splitting and the most common example of reverse splitting is 1-for-10 means that for every 10 shares you own, you will be receiving 1 share extra.
Why it is done?
Now question arises that why stock splitting is done? The first obvious answer is to hit on the psychology of the investors. Another reason that is perhaps more logical one stocks are splitted to increase a stock’s liquidity.
What it means to Dividend Investors?
Stock splitting is a good buying indicator for dividend investors in UK as it signals that company’s stock price is increasing and a good one to buy at the moment.
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