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Stock Splits in Vogue

Nowadays the latest "hot tip' is accompanied by the excited rumor that "stock split aa raha hai", those magic words are all that it takes for the scrip to touch the stratosphere! And post the split what happens? the scrip looses air and settles down to a humdrum existence. So let us understand that what is a stock split really and what does it do to the company's valuation.

Stock Splits is a US term, which means division of high priced shares into a number of low-priced shares, e.g., the splitting of Rs 100 shares into 10 shares of Rs 10 each. Stock splits increase the number of outstanding shares and create a wider and more active market for a company's shares. So what a company really does in a stock split is that it reduces the par value of the scrip in a given ratio. Basically, it is only an accounting entry and there would be no cash flowing in or out of the company. From the shareholder's point of view too, it would not entail any further cash subscription or refund of cash from the company. While the number of shares he holds would increase, the par value of those shares would decrease proportionately. Now this has an effect of boosting the liquidity or floating stock of the scrip as well as makes the scrip more affordable.

Let us look at the affordability concept first. For example a company, say X, has 20 lakh equity shares outstanding in the market. The par value is Rs 10 per share and the current market price is Rs 200 per share. In order to invest in a market lot of the company an average investor would have to put out Rs 20,000. But suppose the par value of the share is reduced to Rs 5 then the share price would automatically fall to around Rs 100. So the investor would have to invest Rs 10,000 for the same 100 shares. So what the management does is that it makes the share cheaper and thus more affordable to a newer class of investor.

Stock splits are frequently prompted when the company's stock price has risen to a level that corporate management feels is out of the popular trading range. At that point, it ceases to be a frequently traded stock and is generally traded only by high net worth investors and institutions leading to a knock-on liquidity. If this happens then the trading volume decrease and investor interest subsides. To overcome this, management declares a stock split. After all how many of us as investors have wanted to invest in blue chips like Infosys and Wipro, but these scrips became some what affordable only after the stock splits were introduced.

Now coming to liquidity. Taking the same example of the company X mentioned above, when the stock splits from Rs 10 to Rs 5 each, then the number of outstanding shares in the market goes up from 20,000 to 40,000. So the liquidity or floating stock of the company also goes up. But one can argue that in this era of demat when an investor can buy even one share of a company how does high price deter the investment? In a demat environment, the concept of market lot does not exist and investors may as well sell and buy shares in single digits as in tens, hundreds or, even, thousands. But investors buying in small lots are certainly not going to increase the overall trading volumes and the problem of low trading volumes remains.

The problem of liquidity is compounded where the free-float of the company is small and the promoters hold a huge chunk of the equity. In the eighties, the companies were restricted by the existence of the fixed par value concept. Companies could not split their shares below the Rs. 10 par value in India as per a government directive issued in the 1980s. But the Securities and Exchange Board of India (SEBI) has now abolished the concept of a fixed par value leaving it to the companies to fix their own par values. At that time companies used the concept of bonus offers to bring down the stock price and make it more affordable. So while bonus offers do make the stock affordable, they also entail transferring funds from the free reserves of the company to the equity capital. This causes the equity to increase and thus in the long run the company has to service this enhanced equity. Therefore, a bonus offer means the payout increases for the company. On the other hand, in a stock-split, the equity capital does not rise; it is just a sub-division of the shares. Therefore, the dividend outgo does not increase.

So how does stock split affect the price of a scrip. Take a look at the following examples -the day the stock split was announced -- the Infosys share ended nearly 4 percent or Rs. 380.25 lower at Rs. 9,234.75 on the Bombay Stock Exchange (BSE). The last share price on pre-split basis for Zee Telefilms was Rs. 6,241 as compared to the first post-stock-split price of Rs. 653. The stock has settled at a level that is 5-7 per cent higher compared to the pre-split market capitalization. The same happened with Wipro too. On an average, the Wipro stock traded at around Rs. 5,114 in the month preceding the stock-split. Subsequently, it settled in the Rs. 1,100-1,300 range. The Wipro stock carries some premium in value, post-split. These instances suggest that stock-splits may have a similar effect to bonus offers.

The broad message from the history of bonus offers since the mid-1990s seems to be clear: Stock prices, post-bonus basis, tend to settle higher if the company 's fundamentals and management are of good quality and the bonus serves the purpose of making the stock more affordable. But as is with the post and pre bonus prices, the ratio of the bonus or in this case the split announced is of crucial importance. Splits can occur at any ratio of new-to-old shares. Several popular ratios are 2 for 1, 3 for 2 and 5 for 4. If the ratio is below the market expectation then the price will react downwards as is with a bonus announcement, and if the ratio is better than expected then the price will be euphoric.

So what does this mean for the investor, should he buy a scrip prior to the stock split or not? Well that would really depend on what the investor is looking for. Of course we all dream of making a quick killing, but to invest in a scrip on the news of a proposed stock split just to cream the price appreciation, may not be a prudent investment decision. An investor as always should take into account the macro as well as micro factors, before investing. Like whether the market is in a bull or in a bear phase, what are the valuations for similar companies in the same industry, what is the rationale behind the spilt, in the past what has been the share price behavior post bonus? All these questions when viewed together will give the investment signal. Remember with a split, the earnings per share would be proportionately reduced, so would be the book value. So in the post-split scene, the scrip will settle at a price which will reflect the confidence of the market in the management, its ability to forge ahead and take on future challenges.

Most analysts believe that companies with a low floating stock between 30 to 40 per cent should definitely go for splits. Because splits help in distributing shareholding pattern widely they put to rest the fear of takeovers and stock accumulation by raiders. In the Indian context, analysts feel that this trend will gather momentum and increase the reach of the markets.

Aru Srivastava