Hello friends, today we will discuss what will happen to the PE ratio after the stock split? You must have heard that a company decides that it will split the share in the ratio of 1: 2 or another company decided to split the share into a ratio of 1:5. First, let us try to understand what a stock split is.
Meaning of Stock split:
For example, if company A has a face value of Rupees 10 and its share price is Rs 1000 and If the company decides that it will split the share in the ratio of 1: 2, it means that a split of 1 share at a face value of Rupees 10 each into 2 equity shares at a face value of Rupees 5 each.
Then after the stock split, the share price will become 1000/2 that is Rs. 500. It means the share price of the company reduces to half and the face value also. I hope you have understood the meaning of stock split.
What happens to PE ratio after stock split:
Now let us try to understand what happens to PE (commonly known as the price to earnings) ratio after the stock split. PE ratio exactly means the price to earning per share ratio. In the above example if the company price is Rs. 1000 before the split and for example earning per share (EPS) is Rs. 10 per share. Therefore, the PE ratio will be 1000/10 that 100.
After the stock split in the ratio of 1:2, now the price is 1000/2 that is Rs. 500 but will the earnings per share remain the same as Rs. 10 per share. No, because before the split, the share number is 1, and earning per share is Rs. 10. After the split, there are two shares, thus the earning per share (EPS) will be 10/2that is Rs. 5. Thus PE ratio will be 500/5 that is 100. Therefore it remains the same before the split and after the split. I hope you have understood that what happened to the PE ratio after the stock split. The answer is no change.
Reasons to split the share:
The next question that might come to your mind is then why a company does stock splits. There may be two major reasons, one is to increase the liquidity as stock split increase the number of shares so by increasing the number of shares it will not be easier to manipulate share price and second reason may be that more retail investors can buy the share at a low price as stock split decreases the price value but there is no overall effect on the valuation of share. According to me, it is just psychological.
I hope you have understood the meaning of stock split, what happened to PE ratio after the stock split, and the reasons for splitting the stock. Please share your thoughts in the comments section. Thanks