A stock split is quite literally a division of a stock/share into two or more additional stocks/shares. When a company does a stock split, the number of shares that the company has increases by a factor. The price of each share decreases by the same factor so that the market capitalisation of the company stays the same.
Ads by Google
A Stock Split Example
If a company has 1000 shares with each share trading at $50.00 per share. The company has a market capitalisation of $50,000. 1,000 shares multiplied by $50.00 per share. The market cap is the total value of the company. If the company does a stock split of 1:10 then each share will be split into 10 shares. However, the price of each of the shares will be divided by 10 so as to keep the market cap. the same as before. This is known as a 10 for 1 stock split and is written as 10:1.
As shown in our example, what actually happens mathematically is multiplication in the number of shares. The 1000 shares are multiplied by 10 and becomes 10,000 shares. A division is done on the price per share so $50 per share divided by 10 becomes $5 per share. Notice once again that the market capitalization remains at $50,000.
Before Stock Split: 1,000 shares * $50 per share = $50,000 Market Capitalisation
After 10: 1 Stock Split: 10, 000 shares * $5 per share = $50,000 Market Capitalisation
Why Do Companies Do Stock Splits
According to Investopedia, there are two main reasons. One being to reduce the perception of investors and the other to increase liquidity.
Stock Splits can Change Investor Perception
Stock prices rise based on either demand, perception or the performance of the underlying company. If the stock price rises too much it might start to appear expensive to investors. This might happen even if the price is justified by the company’s earnings. In such a case, the Directors of the company might propose a stock split. The proposal will have to be voted on by the Shareholders of the company who have the final say. If the shareholders vote for the stock split, the stock split will be approved and effected. Once effected, the stock split will cause a reduction in the price. In most cases, this will remove the perception that the stock is expensive.
Ads by Google
The second reason a company might do a stock split is to increase liquidity of the stock. But what does that really mean? Essentially, this means to make it easier to sell the shares. A stock split makes more shares available on the stock market. However, it is not the only way a company can introduce more shares. What do I mean? Well a company could increase the number of shares on the market by issuing more stock. However, doing so would erode existing shareholder value, which is not a good thing.
I will explain this in more detail in an upcoming article so be sure to SUBSCRIBE so that you will be notified when that post is published.
Increase shares and preserve value
The way to increase the number of shares and preserve shareholder value would be through a stock split. But why would a company need to increase liquidity? There are two reasons. One, a company might want to allow more shareholders into the company. In fact, it is not uncommon for a company to do a stock split just before the company goes public.
The second reason ties back into the previous point made about the stock being perceived as expensive. Earlier we said that if the stock is seen to be too expensive then new investors won’t want to buy it. The consequence of this is that it makes it difficult for investors who already have the stock to sell it. It is difficult for them trade the stock and convert them into cash. This is what they mean when they say something is illiquid. By doing a stock split, the price of the stock comes down but the market value is maintained. Investors who are comparing the company’s stock to others on price alone will feel more comfortable buying the stock because it appears less expensive. Consequently, investors who already own the stock are able to sell the stock more easily.
Stock Split Examples from the Jamaica Stock Exchange.
In May 2016 Pan Jamaican Investment Trust effected a five for one (5:1) stock split. The stock which traded at $121.15 was adjusted to a price of $24.23. PanJam had 250,000,000 stocks issued before the split. Each stock was split into 5 bring the total amount of shares to 1,250,000,000 on the day of split. The following notice was posted to shareholders on May 30, 2016 through the Jamaica Stock Exchanges website.
Pan-Jamaican Investment Trust Limited (PJAM) has advised that at the Annual General Meeting of Pan-Jamaican Investment Trust Limited held on May 26, 2016, the following ordinary resolution was unanimously passed:
“THAT each of the 250,000,000 ordinary shares in the capital of the company be subdivided in 5 ordinary shares each thereby making a total share capital of 1,250,000,000 ordinary shares of no par value at the existing total stated capital of $2,141,985,000 with effect from the close of business on the 31 May 2016.”
In August 2016 GraceKennedy Limited effected a three for one (3:1) stock split. The stock which traded at $124.47 was adjusted to a price of $41.49. Grace Kennedy had 400,000,000 shares in issue before the stock split. After the stock split, there were 1,200,000,000 shares.
Both PanJam and Grace Kennedy are two of the largest companies by market capitalisation on the Jamaica Stock Exchange.
2016 was a year that saw many stock splits on the Jamaica Stock Exchange. Among them were also stock splits in:
Jamaica Producers (JSE: $JP) which effected a 5:1 split.
Paramount Trading (JSE: $PTL) which effected a 10:1 stock split
Kingston Properties (JSE: $KPREIT ) which effected a 2:1 stock split and
Jamaica Stock Exchange (JSE: $JSE) which effected a 5:1 stock split
There were various stock splits in 2017 as well. We will cover those and the results of those splits in an upcoming article.
Do you understand Stock Splits? Test Your Knowledge:
In July of 2016 ABC Electrical Limited effected a stock split that saw the company’s issued shares increase from 2,500,000 to 7,500,000. The share price before the split was $21.
a. What type of stock split did ABC Electrical Limited do?
b. What would the share price be after the split?
c. What would the share price have been if ABC Electrical had done a 5:1 stock split?
Please leave your answers in the comments.
Don’t miss our next article, Subscribe to Caribbean Value Investor