Stock Splits – is it a way of shareholder wealth creation?
The investors should not either be optimistic or be pessimistic to the discloser of stock splits of a listed company.
Stock split occurs where each ordinary share is split two or more shares, e.g., each ordinary share of BDT. 100 each is split into 10 shares of BDT. 10 each. Thus it creates cheaper shares with greater marketability. There is possibly an added psychological advantage, in that investors would expect a company which splits its shares in this way to be planning for substantial earnings growth and dividend growth in the future. As a consequence, the market price of shares may benefit.
Certainty, stock splits is not a method of raising equity finance for new investments rather it is an accounting adjustment only. It produces no extra cash for the company, and it will therefore have no effect on the profits and cash flows produced by the company’s investments. It therefore follows that stock splits should have no effect on total shareholder wealth.
For example, suppose that, a company has 1 million shares in issue, each with current market price of BDT. 500 and nominal value BDT. 100. The company makes a decision of stock splits for each share of BDT. 100 each is split into 10 shares of BDT. 10 each. Before stock splits: The value of the company’s shares before stock splits is BDT. 500 million (1 million*BDT. 500). After stock splits: The number of shares in issue after stock splits is 10 million, because 9 million new shares are issued ((1 million * 10) – 1 million). The stock splits raise no new finance, so the total value of the shares will remain at BDT. 500 million. Hence, the share price should therefore fall to BDT. 50 (BDT. 500 million / 10 million shares).
So, stock splits only affects the composition of paid-up capital, i.e., total number of shares outstanding and nominal value of shares, in the statement of financial position. But unfortunately, it is popular with investors as it is seen as likely to lead to increased dividends. Ultimate result is to hit market price of shares without any fundamental reasons behind it whatsoever.
Last but not the least, any decision in the board of directors of a listed company in stock exchange to split its stocks should not be published as price sensitive information to the investors since it may create controversy with the investors as it has no effect on shareholder wealth. Hence, the investors therefore should not either be optimistic or be pessimistic to the discloser of stock splits of a listed company.