In one of my previous posts (QIP), we had seen the fundamentals of capital structure of a company. Companies need capital to run their businesses and there are essentially two ways of getting the cash – Debt and Equity. At any point of time, a company’s equity is comprised of smaller units of capital called the “Shares”.

Lets take some simple numbers to get our concepts clear. Company A has just been formed and its share capital is Rs. 1000 and is comprised of 100 shares of Rs. 10 each. The original value in which the shares were issued (Rs. 10 in our case) is called the face value of shares. Investors in Company A essentially have two ways of earning returns – 1. Company A could pay them dividends (share of profits) or 2. The value of shares could rise beyond Rs. 10.

The amount of dividend a company pays is a management decision. Companies typically pay a portion of profits as dividends and reinvests the balance profits back in the business. This in turn has the potential to raise the value of shares of the company. Apart from this, the value of the shares of a company could rise or fall for a number of other reasons such as – Performance of peer group companies, status of the economy, strength of management, government policies, stock specific news etc..

Stock split is a essentially a tool available to the management to keep the share price in a particular range, which the management thinks is optimal to attract investors. In our example, lets assume that the company performed well and the price of the stock gradually moved up and ultimately reached Rs. 2000 after 5 years. This price could be quite high and way beyond the means of a common investor to trade in the stock. The management could hence take a decision to split this original share into 10 shares of Rs. 200 each. With this move the face value of the shares also gets divided by 10 and becomes Re. 1 each. A stock split generally increases the liquidity of the stock as more investors tend to include it in their portfolios and so could have a positive impact in the company’s share price. Research shows us that on an average a stock split announcement is associated with a 2% increase in the share price.

While most companies use stock splits to manage their prices there a few exceptions, the most prominent being Berkshire Hathaway. Headquartered in Omaha, US, this company is run by the investment guru – Warren Buffet and has averaged a growth of 20% for the over 44 years now. Thats by no means a small feat.

Warren Buffet never paid dividends and never believed in stock splits and when asked why, always responded that “We want shareholders who think of themselves as business owners with the intention of staying a long time. And, we want those who keep their eyes focused on business results, not market prices”. The result – The price of one share of Berkshire Hathaway touched an all time high of US$ 150,000 (about Rs. 75 lakhs) in December 07.

Many experts argue that Mr. Buffett’s logic of not splitting the stocks is quite puzzling as it is not clear as to how a high price of a stock can attract “better” investor clientele.

That is something for you to think about..

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