Bonus shares and the stock split is common in all stock exchanges across the world. But I used to wonder why companies do it in the first place. Do splits and bonuses really add value to the company or its shareholders? To answer this question, I decided to write this blog post.
I’ll also accept the fact that in the first version of this article, I got it all wrong. Actually, I got confused because of the bonus and split-adjusted price. But I’ll try to make it right in this article.
So allow me to start with the basics first.
- Bonus issue and stock split leads to more wealth creation?
- Bonus share calculation and example.
- Stock Split & its Formula.
- Calculation: Effect of Bonus Shares and Stock Split on Long Term Returns.
Do bonus issue and stock split leads to more wealth creation?
The direct answer is NO. Bonus issue and stock split increase the number of shares held by the investors. But at the same time, there is also a proportional decrease in the share’s market price. Hence, the net effect of the stock split and the bonus issue is zero. It does not create more wealth than it would have done otherwise.
Indirect Benefits of Bonus and stock splits
I would also like to add that, if even the best of companies resort to bonuses and splits, then there must be reasons behind it. Splits & bonuses can make a good stock even more desirable. When the price of a good stock falls due to splits or bonuses, retail investors tend to trade the stock more often. This kind of renewed interest in the stock increases its trading volume. Over time, it is beneficial for investors who hold stocks for very long periods. Why? More demand means faster price appreciation.
Let’s learn more about bonus shares and stock splits.
Bonus Share Calculation & Example
Before you read about bonus shares, I’ll suggest you read this article on authorized capital and paid-up capital. It will help you understand the concept of the bonus shares better.
Bonus share is the issuance of additional shares to existing shareholders (paid-up shares) of the company. This is a simple understanding. But allow me to explain the accounting behind it.
Before Bonus Share Issue
Suppose there is a company that wants to issue bonus shares to its existing shareholders. The shareholders falling under the category of paid-up shares is, say 2 crore numbers. The face value (FV) of shares is, say Rs.5 per share. Hence the total share capital of the company will be Rs.10 crore (=2 crore x Rs.5).
After Bonus Share Issue
The company wants to issue bonus shares in a 1:1 ratio. It means, for every one share held by the shareholder, they will get one additional share. To do this, the company will have to issue 2 crore NEW shares having a face value of Rs.5 each. It means, the company will have to self-finance an additional Rs.10 crore (2 crore new x Rs.5 each) and issue the bonus shares for free to the shareholders. From where the financing will be done? As per rules, it can be done out of the company’s retained earnings. Check the below infographics for the before and after comparison.
Upon the issue of bonus shares, the company’s share capital will increase by Rs.10 crore and its reserves will reduce by the same amount. Hence, after the bonus issue, the share capital will increase from Rs.10 cr to Rs.20 Cr, and Reserves will reduce from Rs.100 cr to Rs.90 cr. But the overall net worth of the company remains unchanged.
Please Note: Upon bonus issue, the paid-up capital cannot become more than the authorized capital. In case the pre-calculations point towards such a happening, the Memorandum of understanding (MOU) document must be amended before issuing the bonus shares. It shall be amended, with the registrar of companies, to increase the authorized capital in such a way that the decided bonus shares can be issued.
Example of Bonus Share Issue
If bonus shares are issued in the proportion of 1:3, it means that for every 3 shares held by a shareholder, they will get 1 additional share. Suppose there is a shareholder who has 30 numbers of shares of a company. Under the bonus shares issue of 1:3, the shareholder will get 10 new shares.
After the bonus issue, the total number of shares held by the person will increase from 30 nos to 40 nos.
While the announcement is made about the bonus share issue, the company also indicates a “record date”. An equity investor must be aware of the term:
- Record Date: It is a cut-off date for the shareholders to become eligible for the bonus issue. On the record date, the sharehoolder must have shares of the company in his/her demat account. Please note that it takes T+2 days (Transaction day + 2 trading day) to get the shares into ones demat account after purchase.
Why bonus shares are issued by the company?
A company would prefer profit-sharing in the form of dividends (cash) with its shareholders. But if they do not want to give cash, they can do it in the form of bonus shares. This way the company will not have to part ways with the cash. A company that is in cash deficit, or is foreseeing a major cash requirement, may decide to issue bonus shares instead of dividends.
Stock Split & Its Formula
A stock split is basically an action taken by the company to reduce the face value of its stock, by splitting it into more shares.
Suppose there is a company whose number of shares outstanding in the market is 1 crore. The face value of each share is Rs.10. The total share capital of this company, as visible in its balance sheet will be Rs.10 crore (=1 crore x Rs.10). Suggested Reading: Difference between face value, book value, market value, and intrinsic value.
Now, suppose the company decided to do a stock split. They wanted the face value of each share to be lowered from Rs.10 to Rs.2. Here the face value is getting lowered by 5 times. Now, in order to keep the share capital unchanged, they must split each share into 5 more shares.
As a rule, the share capital of the company shall remain unchanged after the stock split.
This is a stock split formula
This is a formula that shows a stock split of 1:5. The face value of the stocks is reduced by five times and the number of shares outstanding increases by five times.
In a 5:1 split, for every stock held by the shareholders, after the stock split, their stock holding will increase by 5 times. If a person owns 10 nos stocks before the stock split, after the split he will own 50 nos (=10+40 nos) stocks.
Stock split example in India
- On 24-Mar-2022, Vardhman Textile split the face value of its shares from Rs.10/share to Rs.2/share. This is an example of stock split in 5:1 ratio.
- On 14-Mar-2022, Ramakrishna Forgings split the face value of its shares from Rs.10/share to Rs.2/share. This is another example of stock split in 5:1 ratio.
- On 10-Jan-2022, Ipca LAbs split the face value of its shares from Rs.2/share to Rs.1/share. This is an example of stock split in 2:1 ratio.
Why Company’s Split Their Stock?
Is stock split good or bad? It definitely not bad. But it is also necessary not to overstate its benefits.
We have already seen that the stock split does not change the company’s share capital. It’s market capitalization also remains unchanged. Hence we can say that, in terms of value addition, companies gain nothing from a stock split. So why they do it?
There can be several reasons why a company may opt for the stock split. The first and foremost reason is that it allows companies to keep their stock prices low. What is the logic behind keeping the stock prices low?
It is investors’ psychology that makes them hesitant in selecting a stock whose market price is too high. Hence, good stocks trading at low price levels often have high trading volumes.
Suppose a blue-chip stock is trading at Rs.10,000 per share. Another blue-chip stock trades at Rs.100 per share. What do you think, which stock you are more likely to trade? I’m sure it will be Rs.100 per share, right?
Low price stocks are often investor-friendly. They often exchange hands more frequently than high price stocks. This is the reason why the company split its stocks to keep its market price low. This eventually increases its trading volume.
Calculation: Effect of Bonus Shares and Stock Split on Long Term Returns
Recently I was calculating past returns generated by shares of a few companies. I was trying to calculate the returns generated by them since the day they started trading in the stock market.
Initially, I thought it would be quick work. I’ll pick the end-to-end price and calculate the CAGR (return). If a company got listed in the Yr-2000, then I will note that price. I’ll also record its today’s price. The period between these two dates will be 22 years.
With these numbers in hand, I’ll easily calculate the CAGR using this formula (check this video).
But I soon realized that I’ve missed considering the factor of stock splits and bonus shares issued by the company in the last 20 years. I thought, when I’ll factor in the effect of stock split and bonus shares, the result will be different. Really? Continue reading.
To verify my doubt, I decided to do the return calculation for Sun Pharma. I’ll use two methods to do the calculation. In the first method we will only consider the end prices as visible in the charts.
In the second method we’ll do the whole calculation highlighting the effect of increased shareholding due to splits and bonuses.
The end goal is to check if the return calculated from both the methods match or not.
Method #1 – Considering only end to end prices as visible in charts
It will be a simple calculation. We will calculate the stock price growth rate between the year 2000 and 2022 (22-Years). The price considered for the calculation is Bonus and Split adjusted price. The growth rate so calculated is 20.41% per annum. A normal stock investor will do a price appreciation calculation like this.
Method #2 – Considering actual price & shareholding changes due to splits & bonuses
Now we will do the same calculation after considering the effect of bonuses and splits on shareholdings. The idea is to verify if the return so calculated will be different from what we’ve got in method #1.
The limitation with this method of calculation is that the price quoted in stock charts are all bonus and split-adjusted. To do this calculation correctly we must know the actual price that was paid in the past by the investor to buy the shares.
How to know the actual price of the Sun Pharma stock in the Year 2000. There is an easy way. We will use the theory that the market cap of the company remains the same before and after the stock splits and/or bonus issues. There are two steps to it:
- Step 1 (Market Cap in Yr-2000): First we’ll note the adjusted share price in Year-2000 as appearing in charts (Rs.15.14). Then we’ll note the number of shares outstanding as of today (239.92 crore). Multiplying this price and number of shares will give us the market cap of Year-2000 (Rs.3,632.59). See the below inforgraphics.
- Step 2 (Actual Share price in Yr-2000): The market cap calculated in step #1 will be the same for step #2. Now we’ll note the actual shares outstanding in Year-2000 from Sun Pharma’s financial report (1.54 crore). To calculate share price, divide market cap by the number of shares outstanding. It will be Rs.2,355.31 per share. See the below inforgraphics.
Suppose the person bought one number share in Year-2000. The cost of purchasing the stock will be Rs2,355.31 (as calculated in step #2 above). Over the period of next 22 years, the numbers of shares held by the investor will increase from one to 120 numbers. This will be due to the following reasons:
Stock splits and bonus issue in 22 years:
- Bonus Shares Issued: There was three bonus issues in the span of 22 years. In Yr-2000 at 2:1 ratio, Yr-2004 at 1:1 ratio, Yr-2013 at 1:1 ratio. See the below infographics.
- Stock Split: There was two instances of stock split in the span of 22 years. In Yr-2003 at FV 10 to 5 and in Yr-2010 at FV 5 to 1. See the below infographics.
By the year 2022 (Today), the investor is holding 120 number shares of Sun Pharma. Today, each share is trading at Rs.900.8 per share. Hence, the total value of the investment will be Rs.1,08,096 (120 x 900.8).
It means the invested value has risen from Rs.2,355 to Rs.1,08,096 in 22 years. This is a growth rate of nearly 20% per annum -same as in method #1.
Buying stocks of good companies and holding on to their shares for the long term has its own benefits. But does this benefit gets compounded when the company issues bonus shares and does stock splits? No. But there are indirect benefits of it. This type of corporate action can make a good stock more likable. Hence, the trading volume can increase. Does it improve the returns? Yes, but it is not possible to quantify the proportion of return yielding due to fundamentals and trading volume. If I’ve to guess anyways, for me returns are 95% derived from fundamentals and 5% from trading volume.