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Much ado about nothing

Stock splits and bonus issues attract a lot of attention. They don't deserve that.

Much ado about nothing

Corporate actions happen regularly in the stock market. These events can be of various types, including rights, stock splits, stock dividends, reverse stock splits and so on. Some of these corporate actions are meaningful but some are a mere eyewash, serving no actual purpose. Here, we explore stock splits and bonus issues, which fall under the latter group.

Stock splits
Let us understand stock splits with an example. Two friends, A and B, have ordered a one-kg cake from a cake shop. While A has taken a slice of 600 gm, B has got a slice of 400 gm. Now, consider these two slices as the cake shares owned by two hungry cake-holders who are simply interested in maximising their satisfaction.

A stock split is a corporate event wherein the number of cake-pieces (read stocks) are increased by the cake shop (read the company) without increasing the cake's weight. Simply put, each slice is cut into multiple sub-slices but the actual weight of the cake will remain the same - only one kg. Now, cake-holders will have more numbers of cake-shares but the proportion of the cake shared between A and B will remain the same - 60:40 of one kg. Crucially, there won't be any change in either A or B's hunger level after eating the cake, no matter whether each cake slice is cut into two pieces or 20 pieces.

In a stock split, each share is split into multiple pieces. So, there is an increase in the total number of shares (by a factor of how many shares are carved out from each share) but neither the size of the company nor the proportion of the company held by each shareholder undergoes any change.

Three companies which underwent a stock split in the last six months are

  • Eicher Motors 1:10
  • Laurus Labs Ltd. 1:5
  • APL Apollo Tubes Limited 1:5

Bonus issues
In a bonus issue, the reserves of a company (which already belong to the shareholders) are converted into shares and given to existing shareholders. Although accounting entries are modified here, there is no positive or negative implication from the financial perspective.

Three companies which issued bonus shares in the last six months are:

  • Shrenik Ltd. 2:1
  • Shree Ganesh Remedies Ltd. 3:26
  • Bombay Super Hybrid Seeds Ltd. 1:3

How to read stock split and stock dividends
For stock split, the ratio is usually expressed as '1:y,' where one share is split to 'y' number of shares. For example, a 1:3 stock split indicates that a shareholder having one share will now end up having three shares.

On the other hand, a stock dividend is expressed in the ratio of x:y, where 'x' is the number of the shares received by each investor for every 'y' number of shares held by him/her. For example, a 2:3 bonus issue indicates that an investor would receive two shares for every three shares held. So, if one had nine shares initially, one would actually have 15 shares at the end (six bonus shares and nine originally shares).

Investor takeaways
Shareholders should treat both the events similarly, as their effects are exactly the same. Each shareholder will see an increase in the number of shares held by her, but since the overall value of the company and the proportion of shareholding by each shareholder remain the same, the value of each share will drop proportionally. For example, if a shareholder gets 10 shares instead of one, then the value of the shares will reduce to one-tenth of its previous value.

Stocks of those companies that have recently gone through a stock split or bonus dividend tend to react positively in the short term. The initial consequences of these corporate actions include an increased amount of tradability/liquidity because of lower share prices and a higher number of shares. Theoretically, this should increase the total number of people who are willing to trade shares of these companies, thereby improving its price discovery. For example, most retail investors would find it difficult to buy shares in MRF, which trade at around Rs 65,000 per share. It would be a lot easier for retail investors to own this company if a 1:100 share split is carried out.

But this initial enthusiasm fizzles out soon enough because, as already mentioned, there is absolutely no change in the fundamental value of the company. Long-term investors should simply ignore these financial facades. These are corporate non-events!