Stock split is a psychological as well as a mathematical game. Getting a share for half the price is an encouraging idea. But the split does not always work well. It depends on the mood of the market. In a bear market, this exercise is not much effective. In a rising market, the option is encouraging. The investor gets a feeling that the share price will reach the pre-split level once again very soon. Such developments have taken place in the past and the shareholders have gained substantially. Unbelievable gains are scored by them.
The precise reasons for a stock split decision is known by company's board of directors only. The most common one is 2 for 1. The shareholders will own twice the number of shares originally owned. The value of the total shares remains the same. For example, if you owned 100 shares before the split and the price was $ 100 per share, after the split you would be the owner of 200 shares of $50. The percentage of the shareholder's ownership of the company remains the same. Two factors have changed- the price and the number of shares. The ratio of the split can be anything-3 for 2, 5 for2, and 5 for 1 etc.
One of the reasons, why the companies do this exercise is, the management feels that the price of the share has gone beyond the reach of the common investor. The shares, are generally sold in the lots of 100, and once the price of the share touches $ 100 level, it has been observed that the buying and selling activity for that particular share slumps, as the ordinary investor can not afford high volume transactions. When the price is reduced the investors are on the buying spree again.
By convention and by experience, the message is clear. A prosperous company only goes for this exercise. The company is doing great and probably it will prosper fast. So, it has become the habit with the investors and brokers to look out for such companies. These flag-ship companies and sure candidates for sharp rise in the share prices! One of the tangible advantages of the split is greater liquidity. This exercise by the company is considered as the sign of bullishness. It is seen in the market that the split means the company is doing extremely well and it is the sign of confidence about the future profit-results of the company. Immediately after the split, a short-term rally is seen, but the market does not take much time to stabilize and normalize. The least wanted development can also happen. If the expectations of the investors are not met and the share price falls, they will lose confidence and this may lead to further fall in the share prices.
Reverse split is another mathematical exercise. This practice is resorted to by a company under compulsion and not under happy circumstances. When this happens, a shareholder will have less number of shares for more prices. When the share price drops abnormally, to provide the semblance of respectability, this silent punishment is provided to the shareholders, by reducing the number of shares, thus increasing the price. This is done by the companies to avoid another unfavorable position. The rules in many exchanges are so framed that it will de-list the shares, when the price falls below the certain level continuously for 30 days.
In fine, stock split is a welcome exercise. It enhances the image of the company in the eyes of the brokers and investors and in real terms it has provided substantial gains to them in the past.
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