The moment a company announces a stock split or a bonus, the price of its shares shoots up. But what is a stock split, and what is a bonus? This article presents a comparison between these two, and explains their implications. It also explains the difference between a stock split and a bonus issue.

Do you get excited when a company announces a bonus, or a stock split? Why not – you would say – the moment such an announcement (or rumour!) hits the market, the price of the stock zooms up! But what difference does a bonus or a stock split make to the fundamentals of a company? Is there any fundamental increase in value to warrant such a market reaction?

Let’s find out by understanding these better!

A Little Background

Significance of Shares / Stocks: If you have read "Want to own a company? Buy stock!", you would know that a company issues shares to raise capital (or money) for buying fixed assets, and for its day-to-day operations. The company's promoters provide funds for this, and in turn, they are issues shares or stock in the company.

If the company goes public, its shares are listed and traded on the stock markets. In this case, investors like you and me also become part owners of the company.

Face Value: Each share has a face value to it. This face value is the original value of the share – it’s traded value (that is, its market price on the stock exchanges) can be different from the face value – and it usually is!

Till recently, the face value of shares in India used to be Rs. 10 (or Rs. 100, at times). Now, the face value ranges from Re. 1 to Rs. 100. Common face values are Re. 1, Rs. 2, 5 and 10.

Authorized Share Capital: This is the amount of shares, in face value, that a company is allowed to issue.

For example, if the company’s authorized share capital is Rs. 1,00,000, and the face value of its shares is Rs. 5, it can issue a maximum of 20,000 shares. (Rs. 1,00,000 / Rs. 5 = 20,000).

Note that the market capitalization of the company can be very different from its authorized share capital. For example, if the market price of the company’s shares is Rs. 11, its market cap would be Rs. 2,20,000 (20,000 shares * Rs. 11 = Rs. 2,20,000).

Issued Share Capital: Authorized Share Capital signifies a maximum value – a company’s issued share capital can be less then the authorized share capital. Issued share capital is the amount of shares actually issued by the company, measured in face value (just like Authorized Share Capital).

In our example, say the company chooses to issue only 15,000 shares. In this case, although its authorized share capital is Rs. 1,00,000, its issued share capital would be Rs. 75,000 (Rs. 5 * 15,000 = Rs. 75,000).

Let’s understand Stock Splits and Bonus Issues with this background in mind.

Stock Split

Stock Split is nothing but a change in the face value of the share. If a company decides to decrease the face value of its shares, it is called a stock split.

For example, a company can decide to change the face value of its shares from Rs. 10 to Rs. 2. In this case, each share of Rs. 10 face value would get converted into 5 shares having a face value of Rs. 2 each – so that you keep holding shares of a total of Rs. 10 face value.

In this example, each share gets converted into 5 shares, and this is called a 5:1 or a “5 for 1” stock split.

Similarly, if a company changes the face value of its shares from Rs. 10 to Rs. 1, it would be a 10:1 stock split.

Does any fundamental about the company change due to this? No! The issued share capital remains the same, the revenue remains the same, and the profit remain the same too!

But since the number of shares issued increases, the profit per share (or the Earnings Per Share – EPS) decreases by the same factor.

So, if EPS is Rs. 15 per share for a share having a face value of Rs. 10, after a 10:1 stock split, the EPS would come down to Rs. 1.5. But since you would be holding 10 shares now, your share of EPS remains the same: Rs. 1.5 * 10 shares = Rs. 15, which is as before!

But this has an important impact on stock price: The price of the stock also goes down by the same factor!

And it is natural. For a given Price to Earnings (PE) ratio, if the EPS goes down, the price of the share would go down too.

(To learn more about the Price to Earnings or PE ratio and its interpretation, please read "What is Price to Earnings (PE) ratio?" and "Interpreting Price to Earnings (PE) Ratio").

So, if the PE of the stock is 20 in our example, the price would go down from Rs. 300 (EPS of Rs. 15 * PE 20 = Rs. 300 per share) to Rs. 30 (EPS of Rs. 1.5 * PE 20 = Rs. 30 per share). But again, since you would be holding 10 shares now, your actual holding remains the same: Rs. 30 * 10 shares = Rs. 300, which is as before!

So, there is absolutely no change anywhere, except for the number of shares traded!

And, as you would have rightly guessed by now, there is no fundamental reason for the market to cheer a stock split. The only positive impact it has is to increase the number of shares traded (often called “floating stock” in the market), which improves liquidity.

Also, if the price of the stock is too high, a stock split makes it more affordable to own for small investors.

For example, the face value of Reliance Industries is Rs. 10, and the stock currently trades at around Rs. 2500. If it announces a 10:1 stock split, its market price would become Rs. 250 – and it becomes a lot easier for small investors to invest in it – especially if they are doing it as a part of a systematic investment plan or SIP.

(Please read "Systematic Investment Plan (SIP) - A rupee a day, keeps worries away" to know more about Systematic Investment Plan, or SIP, its advantages, and how to implement it)

Why does market cheer stock splits: Stock market interprets a stock split as a statement of confidence by the company – it interprets a split as a signal from the company that it is confident about its future growth. Also, a stock split increases the number of shares traded in the market, which increases liquidity.

These factors are considered positive, and therefore the market reacts positively!

(Please continue to Page 2 to read about Bonus Issue...)

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