Stock Splits and Bonus Shares

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STOCK SPLIT

What is a Stock SplitWhat is a Stock Split?

All publicly traded companies have a certain number of shares outstanding that are issued and purchased by the investors. When a company’s board of directors decides to split its stock, it basically increases the number of shares outstanding by issuing additional shares to current shareholders. During stock split, the market capitalization of the company remains the same as number of shares are increased through proportional reduction in the par value per share. Stock split affects only the par value of share and the number of shares outstanding. A stock split is also known as a forward stock split.

Let’s consider the following example:

Effect of a 2-for-1 split Before the Stock Split ($) After the stock split ($)
1,000 equity shares of $100 each 100,000
2,000 equity shares of $50 each  — 100,000
Market Capitalization 100,000 100,000

 

The above example clearly illustrates that the accounting values in the market capitalization do not change as the market price per share is immediately adjusted to reflect a stock-split. In the table above, before the split, there were 1,000 equity shares of $100 each, resulting in equity capital of $100,000. After a 2-for-1 split, the number of shares will be 2,000 and the par value of share will be $50. Thus, the total equity value will remain the same, $100,000 (2,000 shares * $50 per share value).

Stock Split

What is a reverse stock split?

A reverse stock split is another version of stock split. It is a strategy through which companies eliminate shareholders that holds fewer than a certain number of shares of the total company’s outstanding stock, causing some shareholders holding less than the minimum required by the split cashed out. The procedure typically decreases the number of shares outstanding and increases the price per share. It is used by the companies to increase its stock price and gain more respectability in the market.

For example, company XYZ has 10,000,000 shares outstanding valued at $2.5 per share, resulting market capitalization being 25,000,000. The company reverse splits its shares 1-for-2 in an effort to reduce its share volatility. This decreases the outstanding shares from 10,000,000 to 5,000,000 and increases the value to $5.0 per share. The market capitalization remains the same as 25,000,000.

What is the significance of the stock splits for the Company?

The advantages of the stock split for the company are as follows:

  • The forward stock splits enhance the liquidity in the market and make shares affordable for the retail investor. High liquidity improves the market efficiency of the stock with the low bid-ask spread.
  • Forward stock splits help to increase the investor base and results in renewal of investor interest of the company.
  • Forward stock splits allow companies to keep stock price in comfortable zone.
  • There is no change in authorized and issued capital of the company.
  • Reverse stock split results in increase in share price and help the company maintain minimum price per share required by the listing criteria of the global stock markets.
  • The company can sideline penny stock traders through reverse stock splits as the price per share inflates.

What is the significance of the stock splits for the Investors?

The advantages of the stock split for the investors are as follows:

  • Forward stock splits make shares more affordable to small investors, particularly when the prices of shares are very high.
  • Forward stock split signals that the price per share of the company is increasing which is a good buying indicator.
  • Investors (being shareholders) get more share because of stock split if bonus shares are issued by a company.
  • No additional amount is required by the investor to acquire shares because of stock split.
  • Stock splits are tax-neutral as there is no flow of money.

What are the disadvantages of the stock splits?

  • Forward stock split makes the stock price more volatile. Generally, a stock with higher volatility is considered as a riskier investment.
  • Stock splitting involve a lot of cost related to shareholder data update, notification letters and other listing exchange and legal requirements.
  • Stock splits represent record-keeping issues for the company’s accountants, shareholders and analysts.
  • Lower price of the stock may attract unwanted shareholders who may buy and sell shares a lot more frequently, causing larger fluctuations in the stock price.
  • Stock split involves a risk of being delisted as it may cause dramatic fall in share price and increases the company’s risk of getting delisted.

BONUS SHARES

BONUS SHARESWhat are bonus shares?

Bonus shares are the free additional shares allotted to existing shareholders in the company based upon the number of shares the shareholder already holds. It is a manner by which a company rewards its current investors just like it does through dividends. The company pays bonus from accumulated earnings which are not given out as dividends.

In short, the reserve funds are converted into share capital, because of which company’s share capital increases while its reserve fund decreases.

Why the companies issue bonus shares?

The advantages of the bonus shares for the company are as follows:

  • Bonus shares is an inexpensive mode of raising capital.
  • It increases the confidence of the shareholders towards the company.
  • Issue of bonus share infuse liquidity, as it leads to decrease in share price and make shares more affordable for retail investors.
  • Issue of bonus shares represent capitalization of profits which help to increase the credit worthiness of the company.

What is the significance of the Bonus Shares for the Investors?

The advantages of the bonus shares for the investors are as follows:

  • Bonus shares are free of cost.
  • Bonus shares can be sold in the market immediately after issued to shareholders.
  • Bonus shares are not taxable.
  • Shareholders will get dividend on more shares than earlier in the future.
  • Bonus improves the image of the company and its shares. Thereby, results in increase in the value of the share in the market.

What are the disadvantages of the bonus shares?

  • The rate of dividend will decline sharply in future.
  • If the rate of dividend fluctuates, it may result in the decline in the market value of shares.
  • It will encourage speculative dealings in the company’s shares which is not desirable.

Conclusion

A stock split is the same share divided into two whereas bonus share is a free additional share. In both cases of stock splits and bonus shares, number of shares outstanding increases and the market valuation of all the shares held by the shareholders remain the same. However, bonus shares are only available to the existing shareholders whereas both existing as well as the potential investors can take advantage of a stock split.

Author: Swati J. – Analyst

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