Before we understand the difference between a bonus issue and a stock split, it would be helpful to learn what shares are all about.
When a limited company wants to raise capital, it issues shares to investors. The shares, which represent units of ownership, are traded on the stock exchanges. They also entitle the holder to a portion of the company’s profits and assets.
What is a bonus share?
When a company makes profits, it distributes a part of it to its shareholders as dividends. The company would reinvest some of the profits for growth purposes, which is recorded in its balance sheet as reserves.
When these reserves swell, the company, with the approval of the general body, issues additional shares from these reserves to the existing shareholders in proportion to their shareholdings. The existing shareholders do not have to pay any amount to the company to acquire these shares. These are bonus shares. The paid-up capital of the company increases with the issue of the bonus shares.
Advantages of bonus shares
- They increase the issued capital of the company. For investors, this makes for a more attractive option.
- Shareholders do not have to pay any tax for receiving these shares. It also brings them additional income.
- Since this adds to the number of shares in the market, the price per share decreases proportionally, making it more affordable.
Disadvantages of bonus shares
- For the company, the issue of bonus shares is more expensive than declaring a dividend.
- There is no additional income accruing to the company.
- The additional shares will automatically reduce the earnings per share because the same profit figure is now being divided among more shares.
What is a stock split?
In a stock split, the company increases the total number of shares by issuing more shares even as it proportionally reduces the price per share. For example, XYZ Company Ltd. already has a paid-up capital of Rs. 1,00,00,000 by issuing 1,00,000 shares of a face value of Rs. 100 each. It now executes a stock split by converting these shares into 10,00,000 shares of a face value of Rs. 10 each. You will notice that although the total number of shares has now increased ten-fold, the paid-up capital remains the same.
A stock split makes shares more accessible to small investors and increases the liquidity of the company’s shares in the stock market.
Advantages of a stock split
- The shares become more affordable.
- Prevents stock prices from increasing.
- Would attract more investors to own shares of the company.
Disadvantages of a stock split
- A stock split could make the shares more volatile.
- A stock split does not lead to the creation of additional assets for the firm. So, the company does not derive any value.
- It adds to the company’s costs.
What is the impact of bonus issue and stock split on share price?
In both cases, the immediate impact is that the share price falls. In a bonus issue, the stock price falls as there are more shares in the market. The entitlement of the shareholder has now proportionately become diluted as well. In the case of a stock split, it falls because the share’s face value has decreased. There are also more shares available in the market. In the long run, investor sentiment, the company’s performance, and market conditions will determine the long-term impact on the share price.
The issue of bonus shares and the stock split do not add anything to the assets owned by the company. Both have its shares of pros and cons. In a bonus issue, the shareholder receives additional benefits at no extra cost, while a stock split ensures greater affordability and accessibility to more investors.
1. How do bonus shares and stock splits affect stock prices?
In both cases, the share prices decrease. In bonus shares, it is due to the presence of more shares—there are more shares among which the same profit has to be distributed. With regard to the stock split, it is because the face value of the shares has decreased. This reduces the proportion of entitlement to the profits and the assets of the company.
2. Which is better, stock split or bonus issue?
The answer to this question is not a straightforward or simple one. The better option would depend on the company’s goals, financial position, and, of course, the overall shareholders’ consent.
3. Do stock splits cause stock prices to fall?
Of course, the stock prices will fall. Stock splits do not bring in fresh capital or an increase in the assets of the company. The existing shares are split, and the number of shares will increase as their face value decreases. The shares now entitle the shareholders to a diminished portion of the profits and the assets of the company.
4. Is it a good idea to buy a share when a bonus has been declared?
Yes, it is a good idea. But please bear in mind that when you buy these shares, there are two scenarios when the bonus is declared. An example would clarify the situation. Let’s say: XYZ Company has announced a 1:1 bonus to its shareholders. Ms. A sells 100 shares to Ms. B. When the bonus is declared:
- If the sale is cum-bonus, then, Ms. B will get the 100 bonus shares along with the 100 shares she has bought from Ms. A. She now owns 200 shares and Ms. A has none.
- If the sale is ex-bonus, then Ms. B will get only the 100 shares she bought from Ms. A, while Ms. A will get the 100 bonus shares. Both Ms. A and Ms. B own 100 shares each.
- The stock exchange will be showing both, the cum-bonus quote as well as the ex-bonus quote.