How Stock Split Works?

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Stock split simply means the splitting of the stock – stock can’t be split, right? – or you can say that splitting of the shares of a company’s stock. Stock split also means the merging of the shares. How come we are talking about the merging of shares when the term is simply written as ‘stock split.’

Let’s dig a little bit deeper.

What's in This Article show

What is Meant by Stock Split?

Stock Split is a corporate action where the company decides to splits its shares in a specified ratio (i.e. stock split ratio) like 2:1 and 3:2 etc. If you know about the bonus issue, you would easily sense that the bonus shares also get distributed by the company in the same manner of ratios.

But in the bonus issue of shares, the company was giving you free shares while here in the stock split, the shares are getting split into furthermore shares. In both corporate actions, you’re getting additional shares, but the way of distributing these free shares is different.

You’ve got to know that a stock split is the splitting of the shares of stock into one or more shares. One can understand that a share is splitting into how many shares by looking at the stock split ratio.

Types of Stock Splits

What is a Forward Stock Split?

You’ll not hear this term, forward stock split, often in the stock market world. Why? because the forward stock split is generally known as ‘Stock split’.

We’ve discussed the definition of the stock split above, that same is the definition for the forward stock split which goes like forward stock split happens when a company decides to split one share of its stock into more shares.

The forward stock split ratios look like these: 4:1 and 3:2 etc. (Go to the starting of this article and read the first line where we’ve discussed some ratios, aren’t the stock split ratio and the forward stock split ratio the same?)

What is a Reverse Stock Split?

You’d heard of the proverb, don’t judge a book by its cover. If one looks at the phrase, ‘reverse stock split’, he/she would think that this also has to do something with the splitting of shares as the phrase, reverse stock split, has the word ‘split’ in it.

But, a reverse stock split has nothing to do with the splitting of shares; despite the stock split, it is the merging of shares.

A reverse stock split occurs when a company decides to merge two or more shares into 1 share. As the merging happens in a reverse stock split, it is also known as a ‘stock merge’.

Some examples of reverse stock split ratios are 1:4, 1:6etc.

Why Stock Split Happens?

Forward Stock Split:

The companies that have high share price split their shares to reduce the share price so that the retail investors, who can’t afford the high price of the stock, can invest in the company which in turn increase the liquidity of the stock in the share market.

For example, say, a company’s share price is Rs 5000. A retail investor can’t afford even a single share of this company; so if a company wants, it can split its stock (through forwarding stock splitting) and make the stock affordable for the investors.

Reverse Stock Split:

The only reason why companies merge their shares using the method of reverse stock splitting is to prevent the possibility of them getting unlisted from the stock exchanges as the exchanges have certain guidelines regarding listing requirements such as the company’s share price i.e. If the stock price of a company is below than a specific price, the exchange can order companies to delist their stock from the exchange.

How Does Stock Split affect Price?

Let’s understand the effect of a stock split on share price by taking an example:

Say, you’ve 20 shares of a company that has a share price of Rs 500.

Forward Stock Split:

Reverse Stock Split:

The important stock split dates will give us a clear idea about the functioning of the stock split. So, let’s discuss some important dates which will give you insight into how stock split works:

Announcement Date: The date on which the company announces that it will split its shares. Other than this, the company also publish the stock split ratio, ex-split date, record date, and Credit date.
Ex-split Date: One has to buy the shares of the company before this date if he/she wants to get the additional shares after the splitting of shares. It is also the date on which the stock starts trading at the new adjusted share price (as the stock split affects the share price).
Record Date: Shares of the company must be in your demat account to get eligible for the stock split. If you do not have shares, you would not be entitled to the additional shares.
Credit Date: The date on which the company transfers the additional shares to your demat account.

Now, you know that if a company is going to split its stock, when would the shares start trading at the new price, when would you get the additional shares in your account, and all other things? Let’s discuss, does a stock split affects your total investment or not.

Your total investment (= no. of shares * share price) does not change. How? Let’s understand, through both cases: forward stock split and reverse stock split.

For example, let’s say, you have 20 shares that are trading at Rs 500 i.e. share price is Rs 500

Forward Stock Split:

Reverse Stock Split:

Is Stock Split Good?

Forward Stock Split:

If the company splits its shares, the shareholders who already have shares of the company will get additional shares and the investors who couldn’t afford the shares earlier because of the high share price, can now invest in the company and rebalance their portfolio.

So, we can say that a forward stock split, or a stock split, is good for the investors.

Reverse Stock Split:

Stock merging is not good at all from an investor’s point of view because the company is merging the shares just to not be delisted. But many retail investors who do not have much knowledge of the fundamentals of the stock market, such as corporate activities, think that the share price of the stock has increased drastically, so we should buy the shares of this company.

And they start buying shares without recognizing the fact what caused the stock price increase and then when they understand that the increase in the share price has nothing to do with the fundamentals of the company, they end up booking losses.

Conclusion

The stock split is a corporate action where the company split its shares that are trading on the stock exchange. The stock split has 2 types: Forward Stock Split and Reverse Stock Split.

A forward stock split is generally known as a stock split and the reverse stock split has nothing to do with the stock split, it is all about the merging of shares. In a forward stock split, no. of outstanding shares increases & share price decreases while the outstanding shares decrease & share price increases during the reverse stock split. This is how a stock split works.

A reverse stock split is an abnormal corporate action that is taken by the company only when the company’s share price falls too much on the stock exchange.