Bonus issues and stock splits are quite common in India, as it is in most parts of the world. The big question is whether these bonus issues and stock splits actually add value to shareholders. In both the cases, the number of shares with the shareholders is enhanced and the price of the share reduces proportionately. Hence in terms of wealth effect, the impact is not material as the increase in the number of shares and the fall in price ex-bonus or ex-split tends to compensate each other. But first let us understand the concept of bonus and split in greater detail..
The gist of a bonus issue..
A bonus issue effectively transfers the general reserves of a company into share capital. The general reserves essentially consist of the share premium collected from shareholders and the reserves created from accumulated profits over the years. Both the share premium reserve and the general reserve are collectively referred to as free reserves, which mean it can be freely distributed among the shareholders. Bonus is declared in terms of the proportionate ratio. Bonus does not change the net worth of the company as it is just a transfer from the reserves to the share capital. Let us understand how the shares of Colgate have grown through bonuses since 1982..
YearStarting SharesBonus RatioBonus FactorEnding SharesAssume that you had bought 1000 shares in 1978 in the OFS at Rs.25 (10+15)19821,0001:12X2,00019852,0001:12X4,00019874,0001:12X8,00019898,0001:12X16,000199116,0003:51.6X25,600199325,6001:12X51,200201551,2001:12X102,400
What the above table indicates is that if you had bought 1000 shares of Colgate in 1978 in the OFS at Rs.25, you would have invested Rs.25,000/- back then. Purely on the strength of the bonuses, your investment would have grown to 102,400 shares. At the current price of Rs.1040/- your investment in Colgate will be worth Rs.10.65 crore. That works out to a mind-boggling compounded annual return of 24% over the last 39 years. But remember, this is not just because of the bonus but also because of the performance and market penetration of Colgate.
How do stock splits work?
Stock splits work slightly different compared to bonuses but the impact is overall the same. It also has the effect of increasing the number of shares and proportionately reducing the price. A stock split effectively splits the face value of the stock. So if the face value of a stock is split from Rs.10 to Rs.5, then it doubles the number of shares outstanding and has the same impact as a 1:1 bonus issue. Similarly, if the stock face value is split from Rs.10 to Rs.2, then the number of shares outstanding go up 5 times and has the same impact as a 4:1 bonus issue. Different companies have different approaches to stock splits. For example companies like Reliance Industries have traditionally preferred to maintain their par value at Rs.10 and instead issue bonus shares to shareholders instead. But most other companies are generally comfortable with splitting the par value of the company since in the post-CCI scenario, the par value is anyways more a theoretical value than a practical value. Stock Splits have a limitation in the sense that once you reach a face value of Rs.1, you cannot split further. Bonuses have no such limits.
Do bonuses and stock splits actually add value?
If you look at the example of Colgate Palmolive India, then the 24% annualized returns over 39 years is something even Warren Buffett would be proud of. However, it is hard to exactly classify what portion of these returns came from performance and what portion came from corporate action. It needs to be remembered that, while being value neutral, stock splits and bonuses are advantageous to the company and to shareholders in 2 ways..
Firstly, stock splits and bonus issues bring the stock price into a popular trading range. Retail and small investors typically prefer to buy stocks that are relatively denominated lower. While it is correct that value has nothing to do with the price, it is true that bringing a stock price within reach is considered to be more investor friendly.
As we have seen in the case of stocks like Colgate, Infosys, Wipro and Glenmark, these corporate actions have been instrumental in sustaining the interest of shareholders over a long period of time. While bonuses and splits do not create value, per se, they are instrumental in catalysing the process of value discovery by making stocks more affordable.
To cut a long story short, bonuses and splits have been generally welcomed by shareholders. It does not change the ROE in any way, but enhances interest in the stock by bringing it within a more popular trading range. That, probably, explains their popularity!