Share splits and bonuses: Gimmick or real value?

Bonus issue

There is no doubt on how we all love to receive free gifts. A bonus issue is an issue of free shares by the company to its existing shareholders, and hence we all love it. This is done by converting a part of the free reserves (i.e. the reserves and surplus accumulated by the company over the years, mainly out of the retained profits) into share capital. The reserves are thus reduced and the share capital increased equivalent to the same amount.

Now lets say a company, with a share capital of Rs 100 crore and reserves of Rs 500 crore, issues bonus shares in the ratio of 1:1. Accordingly, the company's share capital will increase to Rs 200 crore and reserves will reduce to Rs 400 crore. So there is no change in the company’s net worth, which remains the same at Rs 600 crore.

Say you are holding 100 shares in the company and if the current market price is say Rs 200, your investment works out to Rs 20,000. After the bonus issue, your shareholding increases to 200. But does it mean that your investment value increases to Rs 40,000? No, that’s not the case. Since the shareholding has doubled, the earnings per share (EPS) will become half. And assuming that price earnings (PE) ratio remains the same, mathematically the share price falls to half i.e. Rs 100. Thus, your investment remains Rs 20,000. Hence, there is no change to your investment value too. 

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Therefore, essentially speaking, the shareholder is not getting anything free. In fact, he is not getting anything at all – free or otherwise. If it doesn’t make any difference, then why do people ask for bonus issue and how does it benefit them? The reason is – tradability and liquidity.

Psychologically, a stock of Rs 100 share appears cheaper than a stock of Rs 200. Therefore; more people are willing to buy such a stock. Secondly, the number of shares has doubled, which increase the stock’s liquidity. Because of this increased demand and liquidity, the stock usually starts enjoying a better PE.

Therefore, the stock may not fall exactly to Rs 100, but may trade around Rs 110-120. Thus, because of the sentiment, the value may improve a bit to say around Rs.22,000 to Rs 24,000.

But, there is risk too. People are used to receiving certain dividend. Now, because of the increased shareholding, if the company maintains the dividend percentage, it will have to give away double the amount as dividend.

The question arises – does the company generate enough profits to meet this increased dividend outflow? If not, the company will have to reduce its’ dividend percentage. This could have negative impact on the sentiment. Hence, the whole purpose of improving the sentiment may be defeated.

The company and the investor must keep this point in mind, before considering the bonus issue.

Stock split

Theoretically, like bonus shares even stock splits make no difference. The only difference is that while in a bonus issue, the paid-up capital of the company increases, in stock split, the paid-up capital remains the same. In other words, in case of bonus you get additional shares, but in stock split the share you own is sub-divided. 

Stock split is merely, splitting the par value of the share and increasing the number of shares. For example, say a company had issued 1,00,000 shares at Rs 10, three years ago. It now splits the share to a par value of Rs 5 and increases the number of shares to 2,00,000. Therefore, the company’s capital i.e. Rs 1,00,000 does not change at all due to the stock split.

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Again, since the number of shares has doubled, the EPS will halve and the share price will also mathematically halve. So no benefit to the shareholder too. But again, because, the price reduces to affordable levels and number of shares increase, the liquidity and tradability improves and therefore, the price may quote somewhat higher than the exact half.

For example, some time back the price of Infosys’s share was quoting at Rs 10,000. Not many people will buy a share at that price. So the company split its shares and also issued bonus shares so as to increase the number of shares and brought down it’s share price to a more ‘buyable’ value of about Rs 2,000.

Therefore, both bonus issue and stock split do not do anything to add any ‘real value’ to the stock. It is only the improved liquidity (due to more number of shares) and tradability (due to more affordable prices) that can give some kick to the stock.

Note: Warren Buffett, the legendary investor and world’s second richest man (net worth around US$ 42 billion), does not believe in these gimmicks. He has, therefore, never gone for bonus or stock splits in his company Berkshire Hathaway; even though a single share of the company is today traded at around US$ 107,000 and hence out of reach of an ordinary investor. His value investing methods are no secret. But they require a lot of discipline and patience, which unfortunately most of us lack.