What Are Stock Splits and Stock Consolidations?

To be a savvy investor, it is important to have an understanding of how corporate actions will affect you, the shareholder. In this article, we’ll take a look at two specific corporate actions, stock splits and consolidation, and how they can impact you.

Stock Splits

A stock split is a corporate action in which a company divides its existing shares into multiple shares. Although the number of shares outstanding increases by a specific multiple, the price of each share will drop correspondingly to the number of shares created so there is no change in the owner’s wealth. This is illustrated in the table below.

Impact of a 2-for-1 Stock Split on Shareholders
Before Stock Split After Stock Split
Shares outstanding 1,000,000 2,000,000
Stock price $2.00 $1
Earnings per share $0.20 $0.10
Dividends per share $0.05 $0.025
Dividend Yield 2.50% 2.50%
P/E ratio 2/0.2 = 10 1/0.1 = 10
Total Market Value 1,000,000*2 = $2 million 2,000,000*1 = $2 million

Thus, the total dollar value of the shares remains the same compared to pre-split amounts. Stock splits are usually expressed as a ratio. The most common split ratios are 2-for-1 or 3-for-1, which means each old share is split into two or three shares. Companies which have previously announced stock splits are Tritech (SGX: 5NL) and Sino Grandness (SGX: J5S).

Rationale behind a Stock Split

Management view share splits as a positive sign because their stock prices have risen sharply based on the company strong fundamentals and growth prospects. Thus, even though a split may not have an impact on its financials; it often results in renewed investor interest, which can have a positive impact on the stock price.

  1. 1.      Reduce the price of each share – The reduced price of each Share will make the Shares more affordable, encouraging greater participation by smaller investors.
  2. 2.      Increase market liquidity of shares – Cheaper shares will facilitate trading, thus making the shares more accessible and attractive to both existing and potential investors.
  3. 3.      Broaden the shareholder base – The shareholder base of the Company may be broadened and the number of Shareholders might increase as an investment in the Company is made more accessible to potential investors.

Understanding how stock splits can affect your investment decisions over the long run is paramount. Take for example: Wal-Mart where it has split its shares as many as 11 times on a 2-for-1 basis from the time it was listed in October 1970 to March 1999. An investor who had 100 shares at Wal-Mart’s IPO would have seen that little stake grow to a mammoth 204,800 shares over the next 30 years.

Of course, the proportion of the company you own remains unchanged. After all, dividing a pizza into 20 slices instead of ten doesn’t increase the size of the pie, though sometimes I wish it did. But with more shares in circulation, it not only increases market liquidity but it also gives you more flexibility in your portfolio should you ever want to dispose of some of them.

Consolidation (Reverse Stock Split)

Consolidations work just the opposite as stock splits. After a consolidation, your existing shares get reduced and depending on the number of board lots you have previously, you may have odd number of shares which you may have to call your stock-broker for them to sell it off.

Management usually do a reverse stock split to get into the perceived optimal stock price range as some investors may consider stocks with too low a price undesirable. Consolidations are usually done at a time when the companies in financial distress are starting to get back on their feet again but their stock prices are languishing at historical low levels. Two examples of 1-for-10 reverse stock splits are Citigroup (NYSE: C) and Hankore (SGX: B22).

Foolish Bottom-line

While stock prices tend to fluctuate after the proposed corporate actions, ultimately, it is health earnings which will propel stock prices forward in the long run, just like Coca-cola and Walmart. Over the years, they have undergone numerous stock splits and continue to perform well for shareholders. Thus, it is far more important for investors to look for quality businesses rather than trying to take advantage of any corporate actions which may prove to be short-sighted.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo owns shares in Hankore and Sino Grandness.

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