How does a company choose between a bonus and stop split - Motilal Oswal
How does a company choose between a bonus and stop split - Motilal Oswal

How does a company choose between a bonus and stop split

How much can an investment of Rs.10.000 in an equity share grow in 38 years? Frankly, there are no clear answers. But if the company in question was Wipro then an investment of Rs.10,000 in 1980 would have grown to Rs.550 crore in 2018. That is true! If you add up the impact of all bonuses and stock splits in the last 38 years, then your investment in Wipro would have actually multiplied into a mind-boggling number. Here is how!
 

YearBonus / SplitRatio of Bonus / SplitYear Beginning sharesYear Ending shares1980--0100 shares (Bought )1981Bonus1:11002001985Bonus1:12004001986Stock Split100 to 10 FV4004,0001987Bonus1:14,0008,0001989Bonus1:18,00016,0001992Bonus1:116,00032,0001995Bonus1:132,00064,0001997Bonus2:164,0001,92,0001999Stock Split10 to 2 FV1,92,0009,60,0002004Bonus2:19,60,00028,80,0002005Bonus1:128,80,00057,60,0002010Bonus2:357,60,00096,00,0002017Bonus1:196,00,0001,92,00,000

 
At the current market price of Wipro of Rs.293 the value of your holdings today would be approximately worth Rs.563 crore. Effectively the combination of bonuses and splits has helped your investment of Rs.10,000 in 1980 to grow to a whopping Rs.563 crore in 2018. Can we say that bonuses and splits have helped Wipro to create wealth? The answer is clearly “No”. Both bonuses and splits are value neutral and it is the actual financial performance of Wipro that has helped create wealth. What bonuses and splits have done is to keep the stock price of Wipro within an acceptable range so as to elicit investor interest.

Getting into the nuances of bonuses and splits..
Both bonuses and splits result in dilution of the equity base due to increase in the number of shares outstanding. However, since the number of shares goes up and the price goes down proportionately, the net value impact is neutral. So, how do we distinguish between bonus issue and stock split? Why does a company issue bonus shares? Why does a company  split its shares? More importantly, when are stock splits and stock bonuses used by companies and how do they benefit shareholders of the company?

What is a stock split and why..
A stock split is a subdivision of the par value of the share. For example, if the par value of Rs.10 is sub-divided into par value of Rs.5, then it is a 1:1 stock split. The number of shares will double since the par value has halved. At the same time, the stock price will also halve so that the net wealth effect remains the same.

Why do companies take on splits? One of the reasons is to bring the stock within a more acceptable trading range. For example a stock with a par value of Rs.10 is trading at Rs.1200 in the stock exchange. If the par value of the stock is subdivided from 10 to 2, then there is more liquidity available in the market to the extent of 5 times. At the same time the stock price will come down to around Rs.240 and will give a greater comfort level to small and medium shareholders to buy these shares.

There are many companies which are wary about stock splits as they are keen to maintain their par value at Rs.10 and are not comfortable with a par value of smaller denomination. Also there is a limit to the amount of stock split that you can do. For example, a stock with par value of Rs.10 can at best split till a par value of Rs.1; not beyond that. That is why, even in the Wipro case we can see that there have been only two splits but umpteen number of bonus shares given. Let us now turn to the issue of bonus shares.

What is a bonus share issue and why..
Unlike the stock split, which is merely splitting the par value of the stock, bonus actually involves transferring funds from the reserves to the share capital of the company. Effectively, bonus entitlement is for existing shareholders and a company with large free reserves can look to reward shareholders by transferring funds from the free reserves to share capital. Free reserves typically include your general reserves created out of profits and the share premium account. It is a way of rewarding shareholders with stock instead of through cash in a way that is value neutral.

Two things you need to know about bonus and splits..
While there are some intrinsic differences between bonus issues and rights issues, there are two very interesting similarities. Firstly, a split and bonus result in an increase in the number of shares outstanding and proportionate reduction in the market price. In terms of wealth effect, 1:1 bonus is the same as a 10 for 5 stock-split. Secondly, neither the bonus nor the split will impact your Return on Equity. The split only changes the capital constitution whereas bonus entails shifting money from reserves to share capital; both of which are part of the net worth of the company.
 

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