Stock split and reverse split- Evidence from India

Ruzbeh J Bodhanwala
Flame University
Abstract: This study expands on why managers decide to split and reverse split
their companies share and what are the kind of effects they have on the share
pricing and liquidity of shares. This focuses on splits and reverse splits between
2006-2014. Splits declaration were highest in year 2010 (104 companies) whereas
reverse splits were evenly distributed over years. To validate our hypothesis
historical data have been used. The results suggest that there is an optimal price for
the shares, at which they appear to be best value for money. On analyzing the data,
we reached a conclusion that splitting of shares substantially increases the wealth
of shareholders, but no such conclusion can be drawn for reverse splitting.
Key Words: Stock Split, Shareholders, Reverse Split
Introduction
A Stock split (or forward split) is a simple phenomenon where a company
changes the number of shares outstanding and its face value changes with no
effect on any other item of the financial statement. “Reverse splits” is an opposite
phenomenon and is normally done when the share prices reduce substantially and
managers decide to increase the market price by increasing the face value, this
would then reduce the volume available in the market, transaction cost would also
would decrease and in the long run the share will be concentrated in fewer hands.
Since the classic research by Fama, Fisher, Jensen, & Roll (1969) the trading range
and signaling hypothesis is considered as a leading explanation to splits. Also
the existence of abnormal return around splits supports the signaling hypothesis
(Asquith, Healy, & Palepu, 1989), (Grinblatt, Masulis, & Titman, 1984), (Dravid,
1987). Behaviour of reverse splits is associated with negative abnormal returns
and is associated with getting the price in an attractive trading range (Peterson &
Pamela, 1992).
Research on trading range (Baker & Powell, 1993) provided evidence that
managers (91% of managers surveyed ) would opt for share splits when the shares
move out of the trading range ($20-$35), In the Indian context 75% managers in
India opted for split only when the shares were trading outside the ideal trading
range of Rs.400 (Mehta, Jain, & Yadav, 2009). Average price before Split for 519
Stocks (forward splits) covered in the study was Rs.731, and this could have been
a compelling reason to declare splits.
This study focuses on splits and reverse splits between 2006-2014, Splits
declaration were highest in year 2010 (104 companies) whereas reverse splits were
evenly distributed over years. The Indian market (S&P BSE Sensex) is unique in
many ways. Since inception it has given annualized return of 17%. Indian regulator
Great Lakes Herald Vol 10, No 2, September 2016 Page 26
of stock market SEBI, mandates that (SEBI, 2004) Rs.1 should be the minimum
Face value, and majority of splitting companies have deliberately chosen to reduce
their face value from Rs. 10 to either Rs.1 or Rs. 2, which leaves no room for these
companies in the future to split shares.
Reverse split is not very common and it is ironical that all the 38 companies
which declared reverse splits had declared split in the past. The idea behind
declaring reverse split is to increase the share price and concentrate the number of
shares into fewer hands. The end result of reverse split should increase in price and
decrease in volumes.
This study would explore how Indian markets reacted to split and reverse
split announcement as there are contrary opinions across the globe with regards to
change in liquidity and wealth effect. Based on empirical study, we also elaborate
on the implications for short and long term investors.
Literature review
Preferred trading range hypothesis suggests that one of the purpose of share
split is to bring the shares price into a better trading range and improve liquidity
(Baker & Powell 1993); (Lakonishok & Lev, 1987).In the Indian context Mehta,
Jain, & Yadav (2009) validate the trading range hypothesis and 90% of managers
surveyed expressed that ideal price range should be less that Rs 400. Research by
(Lakonishok & Lev, 1987) also proves that firms that declare splits have a higher
short-term growth rate in Earning versus companies which do not declare splits.
A Study by (Ikenberry, Rankine, & Stice, 1996) suggest the splits would help
managers to realign the price to a lower trading range, but their decision to split
is a function of their expected future performance of the company. Fama, Fisher,
Jensen, & Roll (1969) advanced the theory to dividend signals and suggested that
abnormal returns around splits are a function of increased expectation for higher
dividends. The study on dividend signals was extended by (Nayak & Prabhala,
2001) and proved that around 54% of splits announcements can be attributed to
increase in dividend information.
Second, the Liquidity hypothesis (Lakonishok & Lev, 1987) (Ikenberry,
Rankine, & Stice, 1996) suggest that as the share move into a preferred trading
range the stock is in demand by more investors and hence the liquidity of the
stock increases. Study of Copeland, 1979 concludes that there is a decrease in
liquidity after the split event. Study of (Conroy, Harris, & Benet, 1990) (Bley,
2002) concludes that there is no change in volume due to splits.
The Tax timing hypothesis suggests that capital gains on stocks splits occur
when the shares are sold and hence splits offer the receiver a timing option and
capital gains can be deferred. Study of (Constantin ides, 1983) proved that stock
returns are more volatile after splits and hence have a higher tax option value.

Great Lakes Herald Vol 10, No 2, September 2016 Page 27

 The Cash substitution hypothesis suggests that the reason for companies to
declare stock splits is to substitute with lower cash dividends payments. Study of
(Lakonishok & Lev, 1987) suggested that stock dividend is a temporary substitution
for lower cash dividends.
Signaling hypothesis indicate that when managers (who are insiders) are
optimistic with regards to company prospects they would take the decision to split.
Study of Ikenberry et.al 1996 validates the theory with significant post-split excess
returns (7.93% in the first year). Managers as insiders are more aware with regards
to future performance and so a decision of stock split signals to the market positive
sentiments of the managers with regards to future earnings and returns.
Study of Ohlson & Penman, 1985 validates these findings and proves that
volatility of stock return is significantly higher post-split (for splits larger than 2:1).A
Study by Dravid, 1987 extends the work of Ohlson and Penman to all forms of split
and validates the hypothesis that after splits volatility increases. The reverse of a
stock split is reverse split or consolidation and study of Wooldridge & Chambers,
1983 proves that reverse split is associated with abnormal negative returns, the
price of companies declaring reverse splits decline after the announcement date
and after the ex-date. Study of Ohlson & Penman, 1985 provides evidence that
stock return variance (NYSE) increases after the stock split for splits greater than
100% and study of Dravid, 1987 also supports the findings. There is also evidence
of excess return around split which is consistent to the signaling hypothesis. Study
of Asquith, Healy, & Palepu, 1989 extends the argument of information in stock
splits and proves that there is a significant increase in earning four year prior to
the declaration of split and even up to five years after split the increase in earnings
are positive and significant. Study of Kim, Klein, & Rosenfeld, 2008 concludes
that the behaviour of reverse splitting stock is just the opposite of share splitting
companies and there is evidence of negative abnormal return over three years from
the date of reverse split, thereby suggesting that market participants use this as a
negative performance signal.
Attention seeking hypothesis suggest that managers in order to seek attention
of analyst declare splits. Brennan and Hughes (1991) concluded that there is an
inverse relationship between price and analyst coverage and hence in order to get
attention from greater number of analyst covering companies declare splits. Hence,
there appears to be some conflicting empirical evidence.
Objectives
The research objectives of this study are :
• Testing the conflicting empirical evidence with reference to the Indian scenario.
• Measuring the impact of share splitting and reverse splitting stocks on variables
relating to liquidity and shareholder wealth creation.

Great Lakes Herald Vol 10, No 2, September 2016 Page 28

• Measuring abnormal and cumulative abnormal returns around the event dates.
Sample and Data
An initial sample of stock splits during 2006-2014 (9 years) was identified
from Capitaline Database. The splits are executed by firms listed on Bombay stock
exchange. For each stocks split in the sample, this study takes daily information
of split ratio, Ex-Date, closed price, volume, number of trades for 30 days pre and
post-split.
To ensure valid estimates for research following additional issues were considered:
1. Splitting shares are listed on BSE at the time of event.
2. Capital line database should have daily stock prices of these stocks for at least
365 days prior to split for obtaining the slope and intercept.
3. Splitting firm which had undergone reverse split were included in the reverse
split dataset.
4. Splitting forms must have had financial information available for minimum of
30 trading days pre-split and post-split. 30 trading days will transform into 6
weeks, 42 days pre and post-split (total 84 days window). Companies with data
less than 84 days were removed from the analysis.
5. This study uses the adjusted share price and daily return is calculated from
adjusted price. (Adjusted for split factor).
6. Liquidity parameters are adjusted volume and number of actual trades
(unadjusted) pre and post-split.
7. Volatility of stock is measured as the square of daily return (Ohlson & Penman,
1985) (Dubofsky, 1991) (Mishra, 2007).
Research Methodology
Test of significance level, for Price, return, volume and number of trade before
and after split this study relies on few test starting with T-test (paired) as proposed
by (Lakonishok & Lev, 1987) (Mishra, 2007) (Ikenberry, Rankine, & Stice, 1996)
H0= No difference in Mean value Post and Pre Split
H1=Mean values Post and Pre Split are significantly different
Volatility is risk measured by comparing the variability of average mean squared
return pre-split and post-split by using the daily return matching methodology
proposed by (Ohlson & Penman, 1985) (Dravid, 1987) (Dubofsky, 1991) (Koski,
1998).
Non-parametric test (The sign test for paired data) proposed by (Ohlson &
Penman, 1985) is used to validate the robustness of study. Z-test is used to measure
the change in volatility, price, return, volume and number of trades.
Great Lakes Herald Vol 10, No 2, September 2016 Page 29
 In this methodology squared return of the first trading day post-split is
considered matched with first day Pre-split, this matching continues for the 30 days
period before and after split.
As the data points are large a conservative statistical test which does not rely
on specific assumption about the distribution of return like proportionality test will
solve the problem.

Test statistics is simply computed as tallying proportion of cases where the

mean return post-split is greater than pre-split, assuming independence across N
observations.

For all four variables a comparison of average Post-split values greater than pre-
split values is denoted by “Pr.” proportion of cases where Post is greater than Pre.

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Event Time Methodology findings for share splitting firms
A standard event time methodology (Lamoureux & Percy, 1987) (Mishra, 2007)
is used to determine the abnormal return pattern around the Ex-date. The market-
model is assumed for approximating security price movement, also assuming the
standard Gauss-Markov assumptions.

Event day is denoted as day-0 for calculating the Alpha and Beta, regression
coefficients are calculated for 365 days before day-0. From the 365 data pre-split
30 trading days eliminated and result is obtained for remaining days. For each
stock alpha and beta values are calculated based on 335 data points. Critical event
window for analysis is -30 to +30 trading days from the event day and critical
period is tested for abnormal return.
The average abnormal return (AAR) is the average of abnormal return given by
equation 2 :

Subsequently the average Expected return and Actual return for the period +30 to
30 is tested to determine the significance levels (Lamoureux & Percy, 1987).
AAR= Average Abnormal return/ also referred as Average residual (Garcia de
Andoain & Bacon, 2009)
CAAR= Cumulative Average Abnormal return/ also referred as cumulative aver-
age residual
Impact of share split and reverse splits on variables
Table-1 Analysis after share split
Vari- N Mean Dev. Mean Mean Std. P(T<=t) Pr.
ables Pre-split Pre-split Post-Split Dev. Post- two-tail
Split
Price 519 117.8 16.9 122.3 17.0 0.17 0.59
Return 519 0.00 0.03 0.00 0.03 0.00* 0.27
Volume 519 415400.5 512857.4 352114.4 411749.3 0.01* 0.36
Trades 519 947.9 967.5 1342.4 1210.8 0.00* 0.64
*P critical .05
Great Lakes Herald Vol 10, No 2, September 2016 Page 31
P value (t-Test) for variable price is suggestive that there is no difference between
the pre and post-split prices, even though for 59% companies’ average prices of
share post-split were higher than pre-split. For all other variables, it is below the
significance level. H0 is rejected for variables like Return, Volume and Trades. As
can be seen 64% of companies’ experience an increase in trade post-split which
strongly supports the liquidity hypothesis and preferred trading range hypothesis.
Table-2 Analysis after Reverse split
Vari- N Mean Dev. Mean Mean Std. P(T<=t) Pr.
ables Pre-split Pre-split Post-Split Dev. Post- two-tail
Split
Price 38 29.8 8.3 36.9 4.4 0.16 0.37
Return 38 0.0 0.4 0.00 0.02 0.84 0.34
Volume 38 60031.7 86430.6 85031.2 103306.6 0.24 0.71
Trades 38 370.0 378.0 974.3 1041.3 0.24 0.61

*P critical .05
P value (t-Test) on reverse split is suggestive that results pre and post-split are not
significantly different. H0 is accepted on all parameters (price, return, volume and
trades).
Table-3 z-test (nonparametric)

Z-test for splitting and reverse splitting companies

Share splitting firms Reverse split

Variables N z-Stat N z-Stat
Volatility 519 -2.77 38 -4.96
Price 519 -4.08 38 1.44
Return 519 10.67* 38 1.76
Volume 519 6.28* 38 -2.72
Trades 519 -6.36 38 -1.44

z critical at .05 is 1.96

Table-3, z-test suggest no change in volatility for splitting and reverse splitting
stocks. On variables return and volume there is a significant difference for com-
panies splitting shares, suggesting that splits have significant impact on return and
volume.
All variables for reverse splitting shares are insignificant, suggesting that this is
a non-event activity.

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Risk levels
Table-4
Share splitting firms Reverse split
Vari- N Mean Mean Pr. N Mean Mean Pr.
ables Std. Std. Std. Std. Dev.
Dev. Dev. Dev. Post-Split
Pre-split Post- Pre-split
Split
Price 519 16.89 17.01 0.52 38 8.25 4.43 0.29
Return 519 0.03 0.03 0.61 38 0.41 0.16 0.39
Volume 519 512857 411749 0.39 38 86431 103307 0.68
Trades 519 967.53 1210.81 0.56 38 378.00 1041.31 0.55

Table -4 comparison of risk (Standard deviation) indicates that after splits

there is an increase in risk as the number of companies in which the standard devi-
ation of Price, Return and Trades is increasing. The maximum impact can be seen
on Return (61%) and Trades (56%). The findings are in line with previous finding
of (Ohlson & Penman, 1985) (Lamoureux & Percy, 1987).
For companies which declared reverse split there is an increase in risk with
regards to volume and number of trades. There is a considerable fall in mean stan-
dard deviation of price and return for reverse splitting stocks.
Overall conclusion for variables price and return is that there is an increase
in risk for splitting firms and decreases in risk levels for reverse splitting firms,
findings are consistent to the findings of Peterson (Peterson & Pamela, 1992). Al-
most 55% have increase in trades for splitting and reverse splitting firms.
Table-5 (Splitting Firms)

Trading Mean AAR p-values CAAR Pr.

Day Actual
return
-30 0.00 0.00 0.00* 0.00 0.56
-28 0.00 0.01 0.00* 0.02 0.55
-26 0.00 0.01 0.00* 0.03 0.53
-24 0.00 0.00 0.00* 0.04 0.56
-22 0.00 0.01 0.00* 0.05 0.56
-20 0.00 0.01 0.00* 0.06 0.55
-18 0.00 0.01 0.00* 0.07 0.54
-16 0.00 0.01 0.00* 0.08 0.55

Great Lakes Herald Vol 10, No 2, September 2016 Page 33

 -14 0.00 0.01 0.00* 0.10 0.57
-12 0.00 0.01 0.00* 0.11 0.55
-10 0.00 0.01 0.00* 0.12 0.55
-9 0.00 0.01 0.00* 0.13 0.57
-8 0.00 0.01 0.00* 0.13 0.57
-7 0.01 0.01 0.00* 0.14 0.59
-6 0.01 0.01 0.00* 0.15 0.58
-5 0.00 0.01 0.00* 0.16 0.55
-4 0.01 0.01 0.00* 0.17 0.58
-3 0.01 0.01 0.00* 0.17 0.58
-2 0.00 0.01 0.00* 0.18 0.58
-1 0.01 0.01 0.00* 0.19 0.61
0 0.02 0.03 0.00* 0.22 0.74
1 0.01 0.01 0.00* 0.20 0.57
2 0.00 0.00 0.02* 0.21 0.52
3 0.00 0.00 0.39 0.21 0.46
4 0.00 0.00 0.32 0.21 0.47
5 0.00 0.00 0.03 0.21 0.50
6 -0.01 0.00 0.00* 0.21 0.40
7 -0.01 -0.01 0.00* 0.20 0.40
8 0.00 0.00 0.34 0.20 0.47
9 0.00 0.00 0.22 0.20 0.46
10 0.00 0.00 0.25 0.20 0.49
12 0.00 0.00 0.73 0.20 0.48
14 0.00 0.00 0.59 0.20 0.49
16 0.00 0.00 0.76 0.20 0.49
18 0.00 0.00 0.18 0.21 0.51
20 0.00 0.00 0.31 0.21 0.50
22 0.00 0.00 0.10 0.22 0.51
24 0.00 0.00 0.18 0.22 0.51
26 0.00 0.00 0.03 0.23 0.52
28 0.00 0.00 0.06 0.24 0.48
30 0.00 0.00 0.03 0.24 0.52

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Table-5 Indicates the result of t-test, the very first instance where the t-test value
exceeds the critical value is on Day-3 after the Ex-Date (Day-0) or the split execu-
tion date. This indicates that abnormal return continues for 2 days after the event
day. In simple terms markets sentiments for share splitting stocks remain positive
for the 2 days after the event date. 74% of the companies recorded abnormal re-
turns on the Event date.

Chart-1- AAR % (Over Regression Return for splitting firms)

Chart-1, depicts the behavior of Average Abnormal return over the long run OLS
estimates. It is very evident that abnormal return continues for 2 days after event
date, and maximum abnormal return occur on Event date. On event date average
abnormal return is around 2.8% .
Chart-2- CAAR % (Over Regression Return for splitting firms)

Great Lakes Herald Vol 10, No 2, September 2016 Page 35

Chart-2 indicates that the cumulative abnormal return flattens out after Event date
and most importantly it does not decrease, which means that the increase in wealth
of the shareholders pre-split continues in the post-split period.
Table-6 (Splitting Firms)
Variables N Mean Std. Mean Std. P(T<=t)
Pre-Split Deviation Post-Split Deviation two-tail
Pre-Split Post-Split
Ab- 519 0.01 0.03 0.00 0.03 0.00*
normal
return
CAAR 519 0.19 0.42 0.08 0.42 0.00*

*P critical .05
Table-6 Result of t-test concludes that abnormal return and CAAR are significantly
different pre-split and Post-split.
Mean CAAR Pre- Split is around 19%, which indicates that market player
perceive splits as a positive signal and share prices increase abnormally before the
Ex-Date. Between the announcement date and Ex-Date the abnormal movement
can also be attributed to speculation or insider trading (starting almost 30 trading
days prior to the Ex-date, 73% companies had abnormal excess return on Ex-date)
this abnormal movement flattens after the Ex-date.

Trading Mean AAR p-value CAAR Pr.

Day Actual
return
-30 0.00 0.00 0.44 0.00 0.47
-28 0.01 0.00 0.16 0.00 0.50
-26 0.00 0.00 0.16 0.00 0.45
-24 0.00 0.00 0.83 0.00 0.50
-22 0.01 0.01 0.32 0.02 0.58
-20 0.00 -0.01 0.56 0.01 0.39
-18 0.01 0.01 0.46 0.01 0.50
-16 0.01 0.01 0.21 0.03 0.61
-14 0.01 0.00 0.36 0.03 0.45
-12 0.00 0.00 0.81 0.02 0.47
-10 -0.01 -0.01 0.08 0.01 0.45
-9 0.00 -0.01 0.80 0.00 0.34
-8 0.00 0.00 0.77 0.00 0.47
-7 0.00 0.00 0.13 0.00 0.47
Great Lakes Herald Vol 10, No 2, September 2016 Page 36
 -6 0.00 -0.01 0.52 -0.01 0.42
-5 0.00 0.00 0.70 0.00 0.45
-4 0.01 0.01 0.19 0.01 0.47
-3 0.01 0.00 0.57 0.01 0.50
-2 -0.01 -0.01 0.45 0.00 0.26
-1 0.00 0.00 0.39 0.00 0.45
0 0.00 0.00 0.60 0.00 0.37
1 -0.02 -0.02 0.13 -0.02 0.34
2 -0.01 -0.01 0.20 -0.03 0.32
3 -0.01 -0.01 0.18 -0.05 0.39
4 -0.01 -0.01 0.19 -0.06 0.34
5 -0.01 -0.01 0.10 -0.07 0.32
6 -0.01 -0.01 0.08 -0.08 0.42
7 -0.01 -0.02 0.01 -0.11 0.26
8 -0.01 -0.01 0.07 -0.12 0.37
9 0.00 0.00 1.00 -0.12 0.53
10 0.00 -0.01 0.42 -0.13 0.29
12 -0.01 -0.01 0.07 -0.15 0.32
14 0.00 -0.01 0.31 -0.17 0.47
16 -0.01 -0.01 0.17 -0.19 0.37
18 -0.01 -0.01 0.01* -0.21 0.34
20 0.01 0.00 0.68 -0.22 0.47
22 0.00 0.00 0.99 -0.22 0.37
24 0.01 0.01 0.40 -0.23 0.53
26 0.01 0.01 0.37 -0.22 0.47
28 -0.01 -0.01 0.14 -0.24 0.50
30 0.00 0.00 0.82 -0.25 0.45

Table-7 Results of t-test conveys that there is no significant relationship between

the abnormal returns and expected return for reverse splitting stocks. On the event
day there is abnormal return of -0.05% and the cumulative return after 30 days of
the event date is -25%. Findings are similar to the earlier findings of (Wooldridge
& Chambers, 1983) (Kim, Klein, & Rosenfeld, 2008) (Dravid, 1987)

Great Lakes Herald Vol 10, No 2, September 2016 Page 37

Chart-3

Chart-3 highlights that there is no effect of the reverse split news on the stocks
returns. abnormal returns are within the range of +1% to -2%.
Chart-4

Chart-4 for reverse split stocks indicate that cumulative abnormal returns pre splits
are negligible and 30 days after the event date CAAR is around -25%. In fact the
shaded area of negative cumulative returns (after the event date) is much larger in
comparison to the positive cumulative returns (after the event date)
Conclusion
For share splitting stocks there is an increase in liquidity (64% companies had
higher number of trades after split) and the average prices post splits are higher for

Great Lakes Herald Vol 10, No 2, September 2016 Page 38

59% companies but the average price levels are not significantly different. Pre and
post-split return, volume and number of trades are significantly different.
For reverse splitting stocks there is no difference in average levels of price,
return, volume and trades, which concludes that reverse split is a nonevent activity
and there are no market reactions.
The findings of the non-parametric test also suggest that market does not react
to reverse splits and for all variables there is no difference in pre and post behavior.
For share splitting companies, there is a significant difference pre and post- split for
variable return and volume.
For share splitting companies, event time methodology leads to the conclusion
that 73% of companies report average abnormal return on the Ex-Date and average
return is around 3% on the Ex-date. Cumulative abnormal returns flatten out after
the ex-date which signifies that the abnormal increases in share price is permanent
and continues to remain high after the event date. Statistical test also supports the
findings that abnormal return exists between -30 days to +2 days of the Ex-date.
This also indicates that market takes around 2 days after the event date for incorpo-
rating the news of split.
For reverse splitting companies event time methodology leads to the conclu-
sion that the behavior is opposite to the splitting companies and on the event date
abnormal return is negative (-0.5%). On the event date 37% companies reported an
abnormal profit whereas 63% companies had abnormal losses.
CAAR for Splitting stocks after 30 days of the event date is close to 24%
whereas for reverse splitting stock the CAAR -25%.
Taken together stock splits are not merely cosmetic events and majority of the
shareholder do have a permanent increase in wealth. Reverse splits do not achieve
the same purpose and shareholders lose wealth after reverse splits. Shareholders
can maximize profit by selling shares of companies before +2 days; as CAAR
stabilizes after two days of event day. In case of reverse splitting companies, share-
holders can benefit by immediately selling the share (when the news of reverse
split is out) or by short selling the stock.

Great Lakes Herald Vol 10, No 2, September 2016 Page 39

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