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Wednesday, April 28, 2010

Stock Splits - Is it beneficial?

Stock splits may seem like a gift to some investors, but there is little evidence that you benefit in any meaningful way when a company splits its stock.

Here’s what happens. Let say a stock, which is currently priced at Rs 200 per share, announces a 2-for-1 stock split. If you own 100 shares before the split worth Rs 20,000, you will own 200 shares worth Rs 20,000 after the split.

The market automatically marks down the price of the stock by the divisor of the split. The Rs 200 per share price becomes Rs 100 per share.

There are other splits such as 5-for-1 and 10-for-1, however 2-for-1 seems the most common.

It terms of what your holdings are worth, nothing changes. In terms of what the company is worth, nothing changes. So, why do it?

Why Split?

Perception – Some companies worry when the per share price gets too high that it will scare off some investors, especially small investors. Splitting the stock brings the per share price down to a reasonable level.

Liquidity – If a stock’s price rises into the thousands of Rs per share, it may reduce the trading volume. Increasing the number of outstanding shares at a lower per share price aids liquidity.

Is it Good for Investors?

Some investors say a stock split is a sign that a stock is doing well and they consider it a buy signal. You should always look at the whole picture before making an investment decision. If you want to use stock splits as a marker for stocks to consider for further evaluation, that is a reasonable idea, but don’t stop there with your research.

Ultimately, you should buy a stock based on whether it meets the fundamental standards you require and not on whether it will or will not split.