How can the face value of a stock sometimes misguide new investors?
For private companies, IPOs are a great way to get more funds (if approved by SEBI) for their business and become public. Being public means the company’s stocks (shares) are now listed on stock exchanges (such as BSE and NSE in India) to be traded in the securities market.
As part of the IPO process, a company issues a certain number of shares (as per their fund requirements) to the general public whereas each share has a fixed price value called the face value. Usually, it is INR 10 (Rs.10).
So, if a company wants to raise money of amount INR 5,00,000,00 (5 crore) then naturally they will need to issue INR 50,000,00 (50 lac) shares to the general public as the face value of each share is INR 10.
50 lac * 10 = 5 cr.
The general public who applies to the IPO (or in other words subscribe to the IPO) in a way give funds to the company in order to acquire their shares. The amount of money they will need to give to the company will depend on how many shares they want to apply for or the number of shares they actually were allotted by the company (in a way through a lottery system as mostly shares are less to be issued by the company than being asked for by the general public). So this is how a company raise funds by bringing their IPO in the market.
But in this article, we are not concerned about that but it should have already given a better idea about what exactly the face value of a stock is.
Now let’s see how the face value of a stock can sometimes misguide us and as a result of it, we can actually make a bad investment decision.
Small investors usually avoid investing in stocks trading at higher prices as it costs them more money while investing. So, it happens sometimes that a company decides to split the face value of their shares (also called stock split). They usually do this to bring the stock price down so that even small investors can invest in the shares of the company and thus helping to increase the market value as well.
For example, they can split and make each share to the face value of INR 1 (Rs.1) or INR 2 (Rs.2) or INR 5 (Rs.5) from INR 10 (which was during the launch of their IPO).
If an investor is not aware of the stock split he or she may calculate the EPS (earnings per share) of the company as per the old face value.
EPS = net profit/total number of shares issued by the company(in IPO)
Let us suppose the net profit of the company at the end of the year is INR 4,00,000,00 (4cr.).
Let us also assume that number of shares issued by the company during their IPO was 50,000,00 (50 lac).
So, as per the above formula EPS will be 8 as calculated below.
4,00,000,00/50,000,00 = 8
The EPS is 8 only when we are considering the face value as 10 (as during the IPO). Now if the stock split occurs and the face value of the stock is reduced to say 2 by the company then the number of shares will go up to 5 times to the general public. It means if an investor owns 100 shares of the company then after the stock split he will be having 500 shares but of face value 2 (instead of 10).
Due to the stock split EPS of the company will also go down why? This is because the number of shares has now gone up to 5 times which is 2,50, 000,00 (2.5cr).
So now the yearly EPS of the company will be INR 1.6 (Rs.1.6) as per the below calculation and formula.
EPS = net profit/total number of shares issued by the company.
4,00,000,00/2,50,000,00 = 1.6
Now if a new investor is unaware of the stock split or in general if he doesn’t know what a stock split can do to the yearly EPS then he may buy the stock from his wrong idea without knowing about the actual valuation.
He will still think that the EPS is 8 (as per the old face value of 10) and so he will find the stock undervalued (by calculating the wrong price to earnings as per his own assumption) and may buy the stock which may not be good for him. He might still be unaware that the stock price was already adjusted as per the new face value of Rs.2 (on the stock exchanges) by the market participants for that stock. He will consider the price of the stock (which was adjusted on stock exchanges to lower value due to stock split) as per the old face value of 10 which will make the stock highly undervalued.
Even if an investor knows about the effect of the stock split on the EPS still if the new face value or the new EPS has not been updated on the site where he is looking for this info, then again he may be in the wrong assumption and may do the same mistake.
On our site, we always take great care to update for the recent stock split for any stock listed company in India. You can simply make use of the search box as mentioned on the top of every page on our site to find the past 10 years financial data of any Indian stock listed company and also the most recent quarter’s data with everything adjusted if there was any stock split or bonus given or dividend paid.
The precaution to take care is to check properly whether the EPS mentioned is as per the old face value or the new face value (in case the stock split happened).
In general, you should always look at the face value of the stock before deciding to invest in a company. If all the data are accurate then an EPS of 10 with face value 2 for a company stock means an EPS of 50 with the face value of 10. Both are equivalent but there is a huge difference in the price of the stock in both the cases which you need to be aware of. Hope it makes sense.
Written by: Yogesh Lohia.