When a company decides to split its stock, it often raises questions amongst its shareholders. Why would a company split their stock? What are the benefits to the shareholders and the company? When the stock market is performing well, the share prices tend to be higher. A stock split is a way a company can lower the share price, making it more accessible to a wider range of investors. This article will discuss why companies choose to split stock and the advantages that come with it.
A company’s decision to split its stock is driven by numerous factors. One of the most widely accepted rationale is that it lowers the price of the company’s shares, which becomes more attractive to the larger number of investors. This can benefit the company by bringing in more capital for them to use for business operations or growth. Another factor is to increase market liquidity. Splitting the stock can bring in more investors supporting the stock, which increases the trading volume of the stock.
Marc Ruben, CPA, CFP, a finance and tax expert who works with several companies, expresses his stance on this topic. He says “Stock splitting can be helpful for a company, as it can help bring in more capital, increase trading volumes and create more interest in the market. But it should not be the only method used to stimulate growth and investment in the company. It is important to look at the overall investment plan, and evaluate all the alternatives to determine the right approach”.
Companies split their stock for a variety of reasons, including those mentioned above. When a company does split their stock, the share price is divided into two or more lower prices, each with the company’s entire standing of shares. This means that the number of shares of the company increases proportionately. For instance, if a company splits a 10 share lot into two 5 share lots, then the price of one share reduces to half its original price. This adjustment has no impact on the company’s value or net worth and only affects the price.
Splitting a stock can also have psychological benefits for investors that prefer to invest in round-numbered prices and can be attractive to smaller investors who may have a limited budget, allowing them to purchase more shares. By splitting the stock, a company can also help to reduce volatility. Low priced stocks typically have higher volatility, as a small price movement could have a significant impact. Splitting a stock could help reduce this volatility in the prices of the company’s stock.
Overall, stocks splits can be seen as a sign of a healthy company, as it indicates that growth is expected and that the stock is likely to rise in value in the long term. To ensure a balanced approach, companies should mix stock splits with other approaches to ensure growth in the long term.
Different types of Stock Splits
When the management of a company decides that a stock split is the best or necessary option for the growth of the corporation, there are several options to consider. These include reverse splits, stock dividends, forward splits, and bonus issue. Each one has it own advantages and disadvantages.
A reverse split is a type of stock split in which a company reduces the number of existing shares while also increasing the share price. This is usually done to bring a company’s share price above a certain threshold, such as $5 per share, which is often a requirement for getting listed on a major stock exchange. Reverse splits can make a company’s stock more attractive to investors, but can also be damaging to the perception of a company’s financial health.
In a forward split, the company increases the number of shares outstanding while reducing its price. This is a tactic used to make shares in the company more affordable to investors, with the hope that additional investors will increase trading activity and liquidity. This can also be seen as a positive signal from the company that the company’s stock is likely to continue to rise in the future.
Lastly, a bonus issue or stock dividend is a means for a publicly traded company to distribute its profits to its shareholders. It is essentially a stock split in which the company does not reduce its share price but instead issues additional shares to existing shareholders. In this situation, the total value of the shareholder’s holdings remains the same, but they have additional shares which they can trade on the stock exchange. Bonus issues are beneficial to existing shareholders, as they cost the company nothing and increase the number of shares the shareholders hold.
Advantages and Disadvantages
Though stock splits have many benefits, they also come with certain disadvantages. One downside is that a large number of investors may view a stock split as a sign of desperation; this view is unfounded, however, since stocks splits could be a sign of success.
Another potential downside to stock splits is that the company may end up with too many shares outstanding. If there are too many shares on the market, the share price may drop due to a decrease in liquidity. This could pose a risk for the company since it could make it more difficult for them to acquire capital or make other investments.
Despite the potential disadvantages of stock splitting, there are still many advantages. Splits can generate more interest in the company and its stock, thereby increasing its trading volumes. This allows the company to have a larger investor base, leading to more opportunity for growth. It can also lead to increased access to capital as more investors are attracted. Last but not least, it can be a great way to demonstrate the confidence of the management team in the future of the firm.
When discussing stock splits, the issue of taxation must also be taken into account. Generally, a stock split will not have any effect on a shareholder’s taxes. The IRS treats stock splits as non-taxable events, so investors are not subject to any capital gains or losses from the sale of their shares as a result of the split.
However, during the sale of shares after the split, shares sale must be reported for tax purposes. This includes the sale of both common and preferred stock, as well as any options or warrants. The cost basis of the shares must also be adjusted in accordance with the split, so that the tax reporting reflects the new cost per share after the split.
It is important to note that while a stock split itself is generally a non-taxable event, dividends and other distributions from the company are still taxable income. Companies may choose to declare a dividend or distribute profits to shareholders in the form of stock payments. In such cases, taxes must still be paid by the shareholders on these payments.
The Bottom Line
Though a stock split can benefit a company and its shareholders through increased liquidity, wider access to capital, and other psychological benefits, there are still risks associated with it from the perspective of taxation and market perception. Companies should weigh all these considerations before deciding to split their stock, as the decision can have long lasting implications.
Comparison with Other Investment Strategies
The decision to split a company’s stock should be done in conjunction with other investment strategies that form the company’s overall investment plan. Investing in stocks and bonds may be a good strategy to consider, as both can have different levels of risk and return associated with them. Other forms of investments that may be addressed are foreign exchange trading and investing in commodities. Each option has its own specific advantages and disadvantages.
In terms of stock investing, determining the right stock split ratio is also an important factor to consider. It is best to keep the ratio balanced in terms of supply and demand. This can ensure that the stock does not become too concentrated or too diluted, which could lead to either too low of a market share or too low of a liquidity.
In the case of bond investing, investors should be aware of the associated risks and rewards. Bonds can offer a steady income stream with lower volatility compared to stocks. However, the yields on bonds may also be limited in comparison to stocks, and the maturity period for a bond is typically much longer than for a stock.
Foreign exchange trading can provide an additional stream of income, however, the amount of volatility and risk involved must be taken into account. Currency markets can be unpredictable and returns on a trade can vary greatly depending on the currency pairs involved. In addition, due to the complexities of the foreign exchange market, investing in it requires extensive research and careful analysis.
Lastly, commodities can provide a potential hedge against stock and bond volatility, due to their diversified portfolio exposures. In addition, investors can also benefit from changes in prices of commodities like gold, oil, and even cryptocurrencies. Like foreign exchange trading, commodities investing requires extensive research, as the market can be volatile.
Risks and Uncertainties of Stock Splits
Undertaking a stock split carries many risks and uncertainties. The key risks associated with stock splits include diluting the share base, pricing inefficiencies, increased volatility, and incorrect valuation. All of these risks must be taken into consideration before embarking on a stock split.
Dilution of the share base is a risk that comes with stock splits. As stock splits lead to an increase in the number of shares, the value of any single share can become diluted, if it is not appropriately timed and structured. As such, companies must take into consideration the wider implications of a stock split and the potential for it to lead to a dilution in the value of the company’s stock.
In addition, if a stock split is not timed correctly or structured correctly, pricing inefficiencies can result. This can lead to a situation in which the actual value of the company is not accurately reflected in the stock price. This can limit a company’s potential to raise capital from investors, as potential investors may not accurately value a company’s stock.
Lastly, increased volatility is a risk associated with stock splits, as it can lead to large fluctuations in the stock price in the short term. This can be a major disadvantage for investors, as it can lead to significant losses. As such, it is important to weigh all the risks and assess whether a stock split is the right option for a company.