Stock
Split
Meaning
of Stock split
A stock split (or
a Traditional stock split or a Forward stock split) is a corporate action in
which a company divides its existing shares into multiple shares based on the
face value of the share. Basically, companies choose to split their shares so
they can lower the trading price of their stock to a range deemed comfortable
by most investors and increase the liquidity of the shares (to boost the
stock's liquidity). The total value of your shares would remain consistent
compared to pre-split amounts, because the split does not add any real value.
When a stock split is implemented, the price of shares adjusts automatically in
the markets. A company's board of directors makes the decision to split the
stock into any number of ways. For example, a stock split may be 2-for-1,
3-for-1, 5-for-1, 10-for-1, 100-for-1, etc. A 3-for-1 stock split means that
for every one share held by an investor, there will now be three. In other
words, the number of outstanding shares in the market will triple. No impact
will be on taxes by stock split.
Reasons
for a Stock Split
Increase Liquidity
Often, the share price of a company may be too high for investors to buy and any further rise in prices can discourage them from participating. By reducing value of a stock through split, the shares are made accessible to all. The higher number of shares outstanding can result in greater liquidity for the stock, which facilitates trading and may narrow the bid-ask spread. Increasing the liquidity of a stock makes trading in the stock easier for buyers and sellers.
Increase
Stockholder Base
With stock split, the number of outstanding shares of a company increases and it gives opportunity to more investors to purchase shares. This helps increase the stockholder base for a company.
Perception
of Future Growth
Companies going
for stock splits are perceived to be growing entities. It is a general
perception among investors that if a company goes for stock split it has plans
for growth, and this belief creates a positive image of the company in the
market.
What
happens if I own shares that undergo a stock split?
When a stock splits, it credits shareholders of record with additional shares, which are reduced in price in a comparable manner. For instance, in a typical 2:1 stock split, if you owned 100 shares that were trading at $50 just before the split, you would then own 200 shares at $25 each. Your broker would handle this automatically, so there is nothing you need to do.
Are
stock splits good or bad?
Stock splits are generally done when the stock price of a company has risen so high that it might become an impediment to new investors. Therefore, a split is often the result of growth or the prospects of future growth and is a positive signal. Moreover, the price of a stock that has just split may see an uptick as new investors seek the relatively better-priced shares.
Does
the stock split make the company valuable?
No, splits are
neutral actions. The split increases the number of shares outstanding, but its
overall value does not change. Therefore, the price of the shares will adjust
downward to reflect the company's actual market capitalization. If a company
pays dividends, new dividends will be adjusted in kind. Splits are also
non-dilutive, meaning that shareholders will retain the same voting rights they
had prior to the split.
Reverse
stock split
A company that issues a reverse stock split decreases the number of its outstanding shares and increases the share price. Like a forward stock split, the market value of the company after a reverse stock split would remain the same. A company that takes this corporate action (Reverse stock split) might do so if its share price had decreased to a level at which it runs the risk of being delisted from an exchange for not meeting the minimum price required to be listed. A reverse stock split consolidates your shares in a way that results in a higher per-share price that can keep you trading on a public and accessible exchange. Stock split ensures that more people can access the shares and keeps existing shares liquid. While a reverse stock split is often thought of as a red flag for investors, in the long run, it can help a company survive and recover from a rough patch.
In the end, a stock split or even a reverse stock split doesn’t have a huge practical impact on a company’s current investors. A stock split’s biggest impact is on investors who might be watching a particular stock and hoping to purchase a full share for a lower price. For those investors, a stock split can provide a powerful motivator to get off the side lines.
Issue
of Bonus shares
A bonus share is a free share of stock given to current shareholders in a company, based upon the number of shares that the shareholder already owns. While the issue of bonus shares increases the total number of shares issued and owned, it does not increase the value of the company. Although the total number of issued shares increases, the ratio of number of shares held by each shareholder remains constant. An issue of bonus shares is referred to as a bonus issue. When a bonus share is issued, it brings down the EPS (earnings per share) of the company since there are more shares now (the additional shares having no consideration) with the same paid-up capital. Generally, a company is exempted from paying taxes on bonus shares. On the other hand, where a company intends to declare dividends to its shareholders, it has to first pay dividend distribution tax (DDT) which is levied on the company’s earnings. From the investor’s perspective, he/she does not have to pay tax up to a certain limit. Thus, we see that a company is better off issuing bonus shares rather than declaring dividends. Dividend is only paid out of the profits made by the company in a given year. However, the declaration of dividends is contingent upon the decision of the Board of Directors. So basically, dividend is paid out of profits. On the other hand, a company may issue bonus shares even when it is not making profits or is running at a loss. Bonus shares can be issued both ways either out of the current year profits or from the reserves of past years.
Bonus shares and stock splits look deceptively similar insofar as both of them result in an increase in the number of shares, no cash flow is involved and the shares are made more affordable by bringing the market value of each share within an affordable range. However, the main difference between them could be seen in terms of face value and their availability. Bonus shares are only available to the existing shareholders while in case of stock split, the new shares are available to both the existing shareholder as well to any potential investor. Regarding face value of a share, when a bonus share is issued, the face value of the share remains the same while in case of a stock-split, the face value of the share is changed.
Let us consider the example of Mahindra & Mahindra Limited. In the year 2017, it announced bonus shares at the ratio of 1:1 i.e. for every one share that a shareholder held, he/she would get another share without consideration. As on 26th December 2017 Mahindra & Mahindra was trading at ₹ 1,555.90. The very next day, the value of share went down to ₹ 777.95. This explains that when a company issues bonus shares, the value of the share in the market reduces as per the ratio. This is referred to as a dilution in equity. A bonus issue is a signal that the company is in a position to service its larger equity. What it means is that the management would not have given these shares if it was not confident of being able to increase its profits and distribute dividends on all these shares in the future. A bonus issue is taken as a sign of the good health of the company.
After the exercise of issuing bonus shares, the number of shares, obviously increase in the market. Consequently, the EPS reduces. So now when there are more shares in the market, it becomes liquid thereby making it easy to buy and sell. A company thus issues bonus shares also with the intent of encouraging more participation in dealing with shares. Where due to issuance of bonus the supply of shares in the market goes up, the demand of the same accordingly adjusts. The hidden benefit that is accrued to the company is that no sooner does it announce bonus shares than a bulk of investors tries to purchase them.
The balance sheet is not particularly affected because of bonus shares. Bonus shares are issued by converting the reserves of the company into share capital. It is nothing but capitalization of the reserves of the company. Bonus shares involve capitalizing the reserves and relocating the figures from ‘Reserves/Surplus’ column to the ‘Share Capital’ column. No effect is thus observed on the total net worth of a company since there’s no cash outflow.
Example
A company, ABC
Co. had a total of 50,000 shares currently issued with a market price of $150
per share.
The company
announced a bonus shares issue of 1 bonus share for every 5 shares owned. This
means the company issued a total of 10,000 additional shares (50,000 x 1 / 5).
To calculate the
share price after bonus issue of ABC Co., the total value of the shares before
the bonus issue must be determined. The value of the shares before the bonus
issue was $7,500,000 (50,000 x $150).
After the bonus
issue, the number of shares of the company increased from 50,000 to 60,000.
To calculate the
share price after the bonus issue, the total value of shares before the bonus
issue must be divided on the new number of shares. Therefore, the share price
after the bonus issue will be $125 ($7,500,000 / 60,000 shares).
This can also be
summarized in the table below:
People often confuse bonus shares with stock split. Distribution of bonus shares only changes its issued share capital whereas stock split splits the company's authorized share capital.
A bonus issue is considered as an alternative by many companies to dividends. In dividends, a company gives out extra money to shareholders from its net profits, in a bonus issue the shareholders are given extra shares. It increases the share capital of the company and makes it attractive for investors. It is also a great method to increase retail participation. Bonus issue expands a company’s equity base and makes it more liquid.
To
Sum Up
Both, stock split
and bonus issue multiply the number of shares and bring down the market value
however it is only stock split that has an impact on the face value. This is a
key difference between bonus issue and stock split. Bonus issues indicates that
the company has generated extra reserves that it can transfer to its share
capital. Stock split is an initiative to make expensive shares available for a
larger shareholder audience.
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