I’ve written an article on long term investment as a strategy. Experts also write on this topic. But even in their write-ups, you’ll not find an explanation about the effect of bonus shares and stock split on investor’s returns.
What is the effect? For some good stocks, which issue bonus shares and does stock splits, the effect is phenomenal. You can check this video to know how you can calculate its impact yourself.
But why not many people talk about it? Probably the reason is the duration of holding required to see the effect. People need to hold their shares for an insanely long period of time, like 15+ years, to notice the effect of bonus shares and stock split.
Bonus shares and stock splits are not a common phenomenon. I could get a feeling from my study that, in a period of 20 years, bonus shares or stock splits will happen twice or thrice. Hence investors who hold on to their stocks for 3 to 5 years, may not see a stock split or bonus issue even once.
Before going into more details, let’s first know about bonus shares and stock split.
About Bonus Shares
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 issue 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.
Suppose there is a company that wants to issue bonus shares to its shareholders. Its shareholders falling under the category of paid-up shares is, say 2 crore numbers. Face value 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).
Now, the company wants to issue bonus shares in a 1:1 ratio.
From the shareholder’s perspective it means, for every one share held by the shareholder, they will get one additional share.
From the company’s perspective it means, it will have to issue 10 crore more shares having a face value of Rs.5. It means, the company will have to self-finance Rs.50 crore 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 reserves. Read about retained earnings.
Upon the issue of bonus shares, the company’s share capital will increase by Rs.50 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.60 Cr, and Reserves will reduce from Rs.100 cr to Rs.50 cr. Check the above table:
In short, we can say, after the bonus shares issue, Share Capital increases and reserves decrease. The next effect is that the overall net worth of the company remains unchanged.
It must also be noted that, upon bonus issue, if the paid-up capital increases and becomes more than the authorized capital, then the Memorandum of understanding (MOU) document must be amended to accordingly increase the authorized capital with the registrar of companies.
Example of Bonus 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 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.
About Stock Split
A stock split is basically an action taken by the company to reduce the face value of its stock, by splitting it into more number of 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.
Please note this rule – the share capital of the company shall remain unchanged after the stock split.
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.
This is an example of a stock split in a 4:1 ratio. It means, for every stock held by a person, after the stock split he will get 4 number more shares. If a person owns 10 nos stocks before the stock split, after the split he will own 50 nos (=10+40 nos) stocks.
Why Company’s Split Their Stock?
We have already seen that the stock split does not change the company’s share capital. Hence we can say that, in terms of balance sheet numbers, companies gain nothing from stock splits. So why they go for the stock split?
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 it’s 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 one, right?
Low price stocks are often retail 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.
Effect of Bonus Shares and Stock Split on Long Term Returns?
Recently I was calculating past returns generated by shares of 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, in BSE, then I will note that price. I’ll also record it’s today’s price. The period between these two dates will be 20 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. When I factored in the effect of stock split and bonus shares, the result was very different.
I’ll request you to check this video to see yourself the impact of stock splits, and bonus shares on the long term return generated by the company.
Check this video to see how to calculate the return generated by a stock after considering bonus issue and stock splits. Apply the same calculation for companies like RIL, Wipro, etc. I’m sure you will be surprised to see the end result.
To experience the real benefit of bonus shares and stock split, the shareholder must hold on to their shares for a very long time. Here the length of time may be in tune of 15 to 20 years.