Bonus share issue and stock splits are two common corporate measures used by companies to increase the number of shares available for trading. Both of these words are commonly misunderstood by investors. Shareholders are rewarded in a variety of ways by the companies. These benefits can come in the shape of dividends or additional shares. Shareholders do not have to pay anything more in the case of bonus Shares or stock split.
But what are bonus shares and what are stock splits and more importantly what’s the difference between them?
When a company earns a profit, it either distributes part of its profits as dividends and keeps the other part as reserves for future investments. Or sometimes it could keep the entire profit as reserves as well. Over the years, after the payout of dividend, it is possible that the reserve amount grows and becomes substantial. At this stage the company might want to capitalize on this reserve. By this we mean that it will convert part of the reserves into shares. This is called expanding the authorized share capital.
Now how does the company do this?
Let’s say the company wants to capitalize Rs.1,00,000/- (Reserves) At Rs.10/- per share this translates to 10,000 shares. Let’s say there were a total of 10,000 shares in the market at this point in time. So, there are 10,000 shares in the market & there are 10,000 shares created from reserves.
In other words, for every share the company can provide one bonus share. In this situation, we say that the company has declared a 1:1 bonus. Thus, after the bonus issue there would be 20,000 shares in the market.
At this point, it’s important to understand that the market value of the 20,000 shares would be the same as that of the erstwhile 10,000 shares. Hence the value of a single share would fall proportionately. Thus, if the market price of 10,000 shares was Rs.15/- each, the market capitalization was Rs.1,50,000/-.
Now, after the bonus shares have been released the total number of shares goes up to 20,000 but market capitalization stays at Rs.1,50,000/- and hence the price per share falls to Rs.7.5/- (150,000/20,000).
Remember market capitalization is a function of the profits of the company during a year. Therefore, just by issuing shares the profits of the company made during the year does not get affected. Hence market capitalization does not change.
So, to sum up when shares are formed from the reserves and distributed to shareholders, we say the company has issued bonus shares.
In the case of bonus shares, the market capitalization remains unchanged and price of the share in the market drops proportionately in keeping with the number of bonus shares issued.
Now let’s see what’s stock split.
Over a period of time as companies grow and get more profitable their market prices too start rising.
For example, let’s say company’s share value has risen to Rs.10,000/- per share over a period of time. Many people would find it difficult to transact in such a stock because of its high price.
For example, an investor may have only Rs.5,000/- to invest. Such a person would not be able to buy this stock because its price is Rs.10,000/- which is beyond his means.
Thus, to help such investors to participate in stocks where prices have gone up, the company goes for a stock split.
Essentially what it means is to split the stock into smaller units of less value such that its liquidity in the market increases and more investors can participate. So, in our example, the Rs.10,000/- stock could be split in 4 parts, each of Rs.2,500/- in value.
So, whosoever owns a stock of this company, will now have 4 stocks instead.
So, again Rs.10,000/- x 1 stock = Rs.2,500/- x 4 stocks.
Just like in a bonus share here too the market capitalization does not increase.
Thus, in the case of bonus shares, we saw that the company created new shares out of the reserves of the company while in the case of stock split, the split was to reduce the market price of the stock to increase liquidity.
In case of bonus shares, the market reacts positively because by issuing bonus shares the company indicates that it is expected to increase profitability in order to regain the market value of its share.
In case of a stock split the market would react positively as the split was engineered due to high stock price (which also indicates that the stock is good). So, in a sense the market takes notice and reacts positively.
