BONUS VERSUS STOCK SPLITS
There is often a slight confusion with investors about what the two corporate actions – A bonus and a stock split – mean and the impact on the valuation of the company. This brief piece below attempts to elucidate this in simple terms!
WHAT IS A SPLIT
A stock split is very much the same as a mom would cut an eight-inch pizza into 12 slices from four slices in a birthday party! It’s the same pizza but splitting it in smaller pieces means more kids can dig in without piling on each other.
Similarly, during a stock split, the company fundamentals are not impacted : the issued share capital remains the same, the revenue remains the same, and the profit remain the same too. Its just that the face value gets changed. If the same company xyz goes for a 2: 1 stock split , the face value of 10 changes to the face value of 5 and therefore , the quantum of floating stocks will double and simultaneously, the price will get adjusted to half.
WHAT IS A BONUS
A Bonus is a manner by which a company rewards its investors just like it does via dividends. There is an extra financial impact as the shares are funded via reserves. The company pays for bonus shares through the reserves it has accumulated and therefore the conversion results in changes in ratios and free cash. Its almost like a pizza company offering 1 more pizza free to existing clients who ordered one earlier from the profits it made as a reward.
Generally a company issues bonus shares to increase liquidity. When the stock price increase too much it becomes expensive for many small investors. Giving bonus shares increase the number of outstanding shares and reduces the price that makes it more affordable for small retail investors. Issuing of bonus shares also increases the confidence of investors in the company as its rewarding them by converting cash to shares. The post issue market cap remains the same and the price of the share gets adjusted to post issue capital.
Bonus Shares are only available to the existing shareholders while both existing shareholders and potential investors can benefit from the stock split.
As one can see, bonus share results in a reduction of reserve capital which is used to create new shares. Stock split results in reduction of just the face value of the stock.
Typically, bonus share issues are considered more positive because it shows that the company is confident of higher earnings in the future, and that’s why it can afford to issue more shares for free to investors by reducing its reserve capital.
However, in both the cases of stock split and bonuses, the supply of shares increases relative to the demand. Therefore, there could be pressure on share prices in the short term even though in the long term, you might be experiencing an Infosys in the making.
One major difference is in terms of the tax treatment of the gains in both the cases. In case of bonuses, the new shares are received at price of zero, so when calculating the capital gains this will affect the tax treatment (whether each lot is treated as a short-term or long-term gain, e.g.), while in case of splits, the stock price gets halved so the cost-basis of the gain/loss will also get halved.