Why do Companies issue Bonuses and Stock Splits?

Does issuing Bonus Shares or a stock split add value to a company?
Why do Companies issue Bonuses and Stock Splits?
The Case of L&T
The Case of Reliance Power
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Last week we saw one company announce a stock split on Thursda y and another going ex-bonus on the exchange on Friday. Yes, we are talking about L&T and Reliance Power. A lot of folks lost cash (or at least thought they lost cash) on Friday when Reliance Power listed ex-bonus, but did they really lose cash and if they did who was to blame? What exactly happened? What is the deal with splits and bonuses? Do they add value to a company? Let’s find out the answers to these questions!

Bonuses and Stock Splits:
When a company issues bonus shares to its existing shareholders, investors receive a certain number of “free” shares for a given number of shares they own.

For example, if a company issues bonus shares in the ratio of 1:5, this means a shareholder receives one bonus share for every five shares held by him/her. In the case of Reliance Power, the ratio was 3:5 which meant that investors received three bonus shares for every five shares held.

When a company announces a stock split, a share gets divided into more shares (number depending on the ratio of the split).

For example, a 1:1 split means that each share outstanding has been split into two shares. The total shares outstanding in a company are now double what they were in this case.

The difference between a bonus and stock split is that in the case of the former, new shares maintain the same face value of existing shares, while a stock split, “splits” the face value of the share. So, let us say there is a company called QWE and each share of QWE has a face value[1]of Rs.10. If QWE announces a stock split of 1:1, this means each share has split into 2 and the new face value of the split share is Rs.5 each. In the case of bonus shares, there is no change in the face value of existing shares and new shares also have the same face value of Rs.10.
Does issuing Bonus Shares or a stock split add value to a company?Let us answer this question by dividing it into three stages.
Stage 1: Period immediately after announcement of bonus/stock split:

The announcement of a stock split/bonus generally is generally viewed as a positive decision and investors (especially day traders) start to buy the stock and this generally results in an upward rally that may last a few days. In the case of L&T, the stock moved up significantly on Thursday and Friday, following the company’s decision to split the shares of the company. When Reliance Power announced its decision to give bonus shares to its investors, the stock price went up substantially[2].
Stage 2: Time between announcement and actual day of stock split

This is a stage of uncertainty and the movement of the stock generally depends on how long it takes for the bonus/split to actually come into affect from the time of announcement. If this period takes several months (as in the case of Reliance Power) then the stock may correct or may stay range bound. In India, it is generally the case where the actual date of implementing a split/bonus takes a considerable amount of time[3].
Stage3: After SplitOn the day the split/bonus comes into effect, t

he price of a share should theoretically fall in the same proportion as the split/bonus ratio. However, this does not happen in practice. In an ideal situation, if the price of QWE is Rs.100/share and a 1:1 split is announced, the share should list at Rs.50, ex-split. However, this rarely happens since this does not take into account other factors like a gap up opening because of positive global sentiments or some other external/internal developments in the company. Thus, the script may open slightly higher or lower than Rs.50.

In theory, stock splits and bonuses do not add value on their own to a company. Both are simply examples of dividing a pie into smaller pieces. The price of a share of a company is bound to fall after a bonus/stock split.

Why do Company’s issue Bonuses and Stock Splits?If the value of the company remains constant after issuing bonus shares or announcing a stock split, why do companies announce splits and bonuses? Well, the answer is quite simple - it makes the stock “look cheaper”. The valuations of the company may stay the same (i.e. price-earnings ratio, price-book ratio etc), but psychologically the script does look cheap to an investor (at Rs.50 QWE looks cheaper than at Rs.100).

The second reason why companies announce stock splits is since the price of a script is lower; it makes it more affordable to investors. L&T at Rs.3000 is a very high price for one share for several investors and it reduces the opportunity that everybody has in investing in L&T. At Rs. 1,500 a few more investors can chip in and buy some shares. Thus, a stock-split/bonus increases liquidity in a stock and the volume of shares traded increases as well.

This does not however mean that all companies that have shares with high prices should declare splits. Warren Buffet’s Berkshire Hathaway has a price tag of US$134,650 (over half a crore rupees per share) a share and even though only a few hundred shares are traded each day, the company has no plans to declare a split.

Legalities:

In terms of legalities, for a company to declare a stock split, the average price of the stock over the 6 month period preceding the declaration of a split should have been above Rs.500. Reliance Power could not declare a split since the company did not satisfy either condition - it had not been listed for six months and the average price of a share was nowhere near R.500. This could have been one of the reasons why Anil Ambani went for the the bonus option.

The case of L&T:L&T declared a stock split last week and the script went up significantly on both Thursday and Friday. Today morning (Monday), the counter was up for the first half of the day but the fall in stock price during the second half of the trading day can be attributed more towards the negative market sentiment that brought down most stock prices.
The case of Reliance Power:Reliance Power was quoting a price of Rs.386.16 when the market closed last Thursday. The stock officially listed at its ex-bonus price on Friday morning when the markets opened. Now keeping all other factors constant, the stock should have quoted an ex-bonus price of Rs. 241 when markets opened on Friday, May 30th[4]. The stock opened well above this mark and traded in the Rs.230-240 range for most of the day. So did the stock really “tank” on Friday when it went ex-bonus? The logical answer is No. Analysts and investors that were surprised by the magnitude by which the stock price “fell” did not do their research thoroughly.

Yes, traders who bought the script at Rs.450 (before the stock went ex-bonus) and sold their shares on Friday lost money, but wait…. shouldn’t they have done their analysis before entering the script at that level?

Now, if you own Reliance Power shares, you must be asking yourself, “Where are my bonus shares?” The bonus shares will only come into the DEMAT accounts of eligible investors thirty days after the ex-bonus date.

Those who bought their shares on Thursday (the last day before the stock went ex-bonus) received their shares in their DEMAT accounts today. Again, analysts expected the share price to fall this morning (Monday morning), since they suspected that these shareholders would also sell their shares today. However, that did not happen. This was largely because investors knew they had not lost too much if they bought these shares on Friday. Yes, the stock corrected later on in the day, but so did other power stocks and scripts in other sectors. Ideally for a short-term investor, one can wait for an upward rally before taking a decision on selling the script. Long-term investors can simply stay invested!

That’s all from EQUITY BITERS this week. Have a great week and till next time, keep biting into that slice of equity!