Assume a smart, yet crooked fruit vendor. Assume he is the only vendor in a small town so that people don’t have any other resort. During the prime fruit season, he increases the fruits’ prices with increase in demand and people continue to buy fruits from him so that the demand persists. There is an upper break-point limit where people feel or begin to feel that the prices are atrociously high and they would be better off without the fruits. When the vendor increases the fruits’ prices beyond this, demand for the fruits decreases and the vendor incurs loss. A similar scenario exists in share markets. With increase in demand, a stock’s price also increases. The demand is proportional to the trader’s mood. As long as a trader feels that other traders will buy a stock and that its price will increase, he buys it. The buying trend continues till the stock’s price reaches a breaking point. As soon as this break-point is reached, as soon as a trader feels that the stock no longer attracts buyers, he’ll sell it. Once triggered, there can be heavy selling of a stock and its price will plummet in no time.
The primary objective of a stock split is to avoid reaching this breaking point. In stock splits, as the number of shares is increased, the share price decreases. For example, if HCL Technologies initially had 1000 shares, each of price Rs.2000. After a 2-for-1 split, there will be 2000 shares each of price Rs.1000. Hence, though the number of shares increases, the market capitalization of the company remains constant. Not only does this ensure safety of a stock against rapid selling, it also increases the demand for the stock.
Why products are tagged prices of Rs.6999 and Rs.9999 instead of Rs.7000 or Rs.10000? To make them ‘look’ affordable for the buyer. When a person who has no intention of purchasing a product over Rs.9500, say sees this price tag, he is intrigued to inspect the product. In this way, there is a better chance that he will buy the product. It cleverly utilizes people’s mentality to be allured to cheap looking products. Similarly, a trader will go after a stock which is affordable or looks affordable to him. So, when a stock’s price rises very high, the company’s planners split the stock to make it affordable to traders to whom the stock’s price was earlier prohibitive. Hence, the stock’s demand increases after a split.
From an investor’s point of view, a stock split means he has more shares to trade and psychologically he feels good. A more plausible reason is that stock splits increase the liquidity of the stock. As the liquidity increases, so does the number of trades of the stock and hence its volatility. Simply put, more number of shares implies more trades and more trades of a stock imply faster increase in the value of the stock.
All these impacts of stock split can be summarized with an example. Assume a company has 1 million shares that are public and each share costs, say $5. So the company’s net market capitalization is $5 million. Now, if the company splits the stock as 2-for-1, then there will be 2 million shares, each of worth $2.5 now. The total market capitalization remains the same ($5 million). If a trader was planning to buy shares for $100, earlier if he had bought this company’s shares, he would have got only 20 shares. Whereas, now, with the same amount, he can buy 40 shares and it sure is comparatively more attractive to him than 20. Further, as the number of shares of the company has increased by a million, there will be more number of trades of this company’s shares in the market and subsequently, its share value can rise to its earlier value of $5 in a much shorter time.
An associated problem with stock splits is the commotion and tumult that it is likely to cause. To prevent brokers from gaining out of stock splits, no prior information is given about the split. So, due to stock split, if the value of a stock suddenly plunges from $6 to $3, there will be great commotion amongst the investors who might think that the share market has collapsed. To avoid this, something called adjusted closed price is followed. Due to this, it will seem as if the price of the stock was always $3. A stock split is an indication of well faring buying trend of a company’s stock.