Stock Split/Bonus

OutlookMoney online 11/8/10

Bonus Issue

In a bonus issue, a company gives free shares to its existing shareholders on a pro rata basis. For instance, if a company declares a bonus of 2:1, the investor gets two additional shares for each share he holds. This, however, does not mean that the company has raised additional capital.

Instead, it converts some of the free reserves (accumulated profit over the years that has not been distributed as dividends) into share capital and issues it to you as shares. The net impact is that the reserves decline and the share capital increases. And that’s exactly the logic behind giving bonus: it converts some of the excess reserves into share capital.

What it means for you A bonus issue increases the number of outstanding shares of a company and, therefore, its earnings per share (EPS) declines. Theoretically then, the share price should also fall by the same factor as the decline in EPS, making it negative for investors. However, as investors get newly issued shares, their overall wealth remains the same. In a nutshell, a bonus issue doesn’t impact investors’ wealth. Hence, it is wrongly seen as a reward to shareholders.

Stock split

It is the division of a share into multiple shares. For example, if a company splits its shares in the ratio of 2:1, it divides one share into two. So, if the face value of a share is Rs 10, it becomes Rs 5 following the split. In effect, by breaking the face value of share, the company tries to boost the liquidity of its shares.

What it means for you As in the case of bonus shares, following a stock split, the number of outstanding shares increases and EPS declines. Therefore, the price also falls (theoretically, in the example above, the market price of the share will be halved). But as investors have more shares after a stock split, their wealth remains unaffected.

Key takeaway

Your wealth remains unaffected both in the case of bonus issue and a stock split. Do not get caught in the market frenzy following these events, or you will end up overpaying for these stocks.

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