The advantages of investment in the stock markets is plentiful. Some fail to venture into stocks as investment as the fear of failure in the markets outweighs potential gains. There is risk, no doubt. This is true when the stakes for earning rewards are high. However, if investors do their research quite diligently, there are more rewards from owning stocks to be had, rather than disappointments. One of these, and a significant reason to invest in a solid company’s stock, is the aspect of the stock bonus.
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 stock 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.
If you have ever attended an AGM of any company, you may find that investors demand bonus shares of the company from the company’s management. Novice investors are of the opinion that bonus shares increase their investment value in the company. This may be further from the truth than investors believe. Bonus shares issued by any company do not really add any value, unless in the event of one case. If the company in question increases the payout of the dividend on a per-share basis, then the bonus shares have some meaning for investors. This invariably translates to more cash in terms of dividends received.
How do stock splits work?
The difference between a bonus and a split should be clarified. This is because both these aspects of stock investment may benefit investors, but they are distinct in their working. Stock splits work slightly differently 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 goes 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. In knowing about the difference between a stock split and a bonus, you get to find out which adds value to a stockholder (if any value at all).
Do bonuses and stock splits actually add value?
If you look at the example of Colgate Palmolive India, then the 24% annualised 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. In terms of bonus shares vs stock split, 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. They tend to add some notional value which is important in terms of the mindsets of different investors. They may not add physical value in a straightforward manner, but they do encourage investment a lot more than other factors influencing new investors to enter the foray of stocks and shares.
In case you are still wondering whether there is any wealth creation when bonus shares are issued or stock splits occur, the clear answer seems to be a “No”. Both bonuses and stock splits may increase the amount of shares held by investors at any given point in time. However, it is vital to remember that while bonus shares and stock splits increase the number of shares, they also decrease the market price of shares. However, this should not be seen as a negative consequence of stock splits and bonuses. In fact, when a solid company’s stocks rise in the markets, your increased number can see you gaining rich rewards.
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! If you hold a good stock, like any blue-chip stock, bonuses and splits can only make stock more appealing to investors. The activity of rigorous trading occurs when splits and bonuses occur, and this is typically due to the fact that the stock price falls at this time. This, in turn, raises its trading volume. Over a long period, this may trigger gains for a particular company stock. The more demand there is, the more is the price appreciation, and the quicker it occurs, furthermore. All in all, these may not add any immediate value, but their long-term potential is positive.
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